Zero skew, or even negative skew, can be favorable. Once skew starts rising, options traders might want to think twice before entering a calendar spread.
There’s an important concept that options traders who trade calendar spreads should understand. It's called skew.
Skew is used in a few different ways, but in this article we’ll use it to quantify the difference between the implied volatilities of two options that make up a calendar spread. Importantly, we’re going to use skew to help make decisions before placing the trade.
First off, remember that implied volatility is a way of defining the price of an option. What we’re looking for with skew is a filter for potential calendar spreads.
With a calendar, traders buy a longer-term option and sell a shorter-term option. If the price of the short-term option is high, that might look great at first because this could make the calendar cheaper.
But the higher option price might mean it also has higher implied volatility. If that higher volatility creates a big difference, or skew, between the long and short option, then this could signal a potential problem.
Consider this hypothetical scenario:
This calendar is trading for $0.50, which seems low because of the relatively high implied volatility in the June call. There’s obviously a skew, or difference, between the volatility of both options, but it’s helpful to quantify this difference as a percentage. Here’s a quick way of doing this: Divide the short option’s volatility by the long option’s volatility, then subtract 1.
The skew is calculated by dividing 0.35 by 0.25 (1.4), and then subtracting 1. This gives us a skew of 40%. In other words, June volatility is 40% higher than July volatility. And that might indicate a problem. Why?
The question to ask is, “Why is June volatility so much higher?” The answer might be that there’s some sort of event going on before June expiration. This could be an earnings announcement, an FDA announcement (if this happens to be a drug company), or even a court ruling. The only way to find out is to do a little homework and research the company. You might be able to find out rather easily what’s going on by searching the news for a specific stock. But keep in mind that the June option has less time until expiration and volatility could be higher because of this. Also, because the June option has less time value, any market event could have a bigger impact.
The danger of trading a calendar in this situation is that high volatility in June is discounting that the stock could have a big move. This is during a time when a trader would want the stock to sit still. So although the low price of the calendar can be enticing, a trader could very well see the low price of the calendar get even lower and possibly drop to zero if the stock makes a big move.
When looking at skew, how much is too much? There’s no easy answer here. A skew of zero, which is when both option volatilities are the same (or roughly the same), tells you the market is not really expecting anything out of the ordinary. This might generally be favorable—assuming that the overall volatility isn’t high and at risk of collapsing, dragging premiums down with it.
Try to take note of the skew when considering a calendar spread. Zero skew, or even negative skew, can be favorable. But once the skew starts rising, traders might want to think twice before putting on a calendar spread.
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