Change text size

• Email This Article
• Print This Article
• Digg This
• Delicious
• Subscribe

Part of the key to successful trading is creativity accompanied by the occasional impulse to think outside of the box. That is, in order to achieve success, we sometimes have to look outside of the usual checklists and places. This is the thought process of true contrarians. The introduction of Platinum 3.0 introduced many powerful new features, one of the most remarkable being the Skew Finder. Quite simply, the Skew Finder feature attempts to find the percentage difference between implied volatilities over different time periods. The original idea for this search function was to find high short-term IVs to sell and low longer-term IVs to buy within the same stock. What has been found empirically, however, is a potentially more powerful application of the Skew Finder function – one where we assume that the majority is actually right. In addition, they give us a chance to be right alongside them.

A Little History

We begin by giving a little history on the discovery of this technique. I want to be clear that I do not claim to have invented the technique. Options and probabilistic trading techniques have been around for centuries. If anyone claims to have invented something, they should be reminded that they have merely discovered it for themselves.

Throughout the past six months, I became interested in large stock moves. It just seemed that students insisted on trading stocks after a large move. I found that there was an enormous amount of work to be done after the fact. Furthermore, everybody was already analyzing the stock after the move. The question was, then, is there anything that can help us take advantage of the move before it happens?

From my days as a floor trader, I remember times when a relatively quiet stock would suddenly fall prey to heavy options trading. The activity would usually last no more than a few days. Afterwards, the stock would make a sizable move. Somebody obviously knew something. I always wished I could have stepped off the floor to buy alongside those who knew what I did not.

At first glance, it seems like an easy thing to track. If insiders were bullish they would buy lots of calls. If they were bearish, they would buy lots of puts. However, any professional trader with just a mere education on synthetic relationships knows that the world is just not that simple. There was no way to predict the direction of the move even though everyone knew something was about to happen.

The excessive purchase of options means that as market makers we have to adjust option values to reflect current supply and demand. When there is excessive option buying, market makers have to raise the option values even if the stock price does not change. This is reflected by an increase in the IV of the options. Since front month options have the lowest vega, it makes sense that they would experience the highest increase in IV in order to change prices accordingly. By the same token, due to the large vega of longer term options, the rise in IV of those options would not be as pronounced. This is precisely what creates the percentage difference in IV between options of different months. An example of this phenomenon is seen in the picture below:
Figure 1: ATM Implied Volatility

The above picture looks similar to what happens to the IV levels once a stock has made its move. The question then is, can we find this relationship in stocks BEFORE the move? The answer is yes. That’s where the Skew Finder function comes in.

Using the Skew Finder

Clicking on the Skew Finder function in Platinum will give us the following screen:

Figure 2: The Skew Finder

While the screen may seem overwhelming at first, we do not have to change much to the parameters to make them functional. Let’s go through the two steps.

Step 1: Ranking Criteria

We leave the first two rows unchanged. We want at-the-money options for both long and short-term options.

Under days to expiration of the primary option, we want to capture either the front month or if we are within the last week of expiration in the front month, we want to capture the second month. Hence, the range of trading days would be 5 to 35.

The days between expirations would remain unchanged since the default range would capture just about every relevant scenario.

The minimum volume level would be zero, but the minimum open interest number would be 1. The reason for 1 is that in the case of multiple options such as merger stocks, we want to give ourselves the best chance to pick the relevant options in the chain. Knowing that there is at least some open interest helps us narrow things down.

As for call or put skew, it doesn’t matter. Call and put volatility must be equal across equal strikes and months. However, due to the exclusion of dividend data in Platinum, our analysis will be more precise if we consider put skew rather than call skew.

For the skew levels, beginners should start with a minimum skew level of at least 65 percent. More advanced users can continue to lower the minimum skew level to 40 percent. The maximum skew level should be set at some unreachable level such as 500 percent just for the sake of giving a number.

The minimum bid and ask for options can remain unchanged as we will rarely approach those levels. Changing them would just be adding unnecessary work. That makes our screen look something like this:

Figure 3: Choose Stocks to Rank

The only parameter to change here would be the number of stocks displayed. If we lower the maximum from 100 to 25, we will have more than enough stocks to consider. Besides, we will also save ourselves unnecessary work.

Interpreting The Results


Figure 4: The Results

Notice that the first choice in this output was from Cyberonics (CYBX). The first thing to note is the actual IV of both months. The back month IV was 102, the front month was 303. Hence, 197 percent skew is a percentage difference worth examining. The reason IV levels are so important has to do with the Optionetics definition of skew. It is quite simply defined as the percentage difference in IV between the back month and the front month. Hence, we take the difference between the IVs (303 – 102 = 201) and we divide by the back month IV (201/102 = 197.18%). You can see from the definition that if our back month IV was, say 5 percent, then an IV of 9 percent in the front month would reflect 80 percent skew. Clearly, there is nothing to get excited about in that scenario. For starters, I would make sure that the back month IV is at least 40 percent. That way, we only consider significant nominal differences in IV.

The second thing to do is to click on CYBX and look at the stock chart and the IV chart. The pictures below show what we get:

Figure 5: IV Spikes, CYBX

Notice the enormous IV spikes even though nothing has happened in the stock price! Why is everyone paying so much for options and creating such large skew if nothing has happened? Are these people simply throwing away millions of dollars or do they possibly know or anticipate something happening in the near future?

Let’s fast forward a few days and see what happened in our stock:

Figure 6: IV Retracement, CYBX

There are two critical observations to make here. First, the stock almost doubled in value in less than 2 weeks. In fact, the move was quite sudden. Second, notice the red line in the IV chart. Now that the event is over, the IV levels have retraced back to normal levels. This happens very quickly. Market makers do not sit around waiting for people to capitalize after the fact.

So the question now becomes, how could a retail trader have capitalized on a large expected move? The answer is simple: You capitalize the same way that you would on ANY expected move. You buy options. If we look at the option chain for CYBX before the move, we get the results pictured below:


Figure 7: Options Chain, CYBX

Notice that if we use July options, we could buy the July 12.50/30 strangle for $2.05 – and that’s if we do not shave the prices. On a minor note, the largest open interest in July options lies in the 12.50 puts. Given that we know the stock spiked to $38/share within a few days, we know that open interest does not give ANY indication of direction. In fact, this is a completely non-directional situation. That is why we are buying both sides of the trade.

So What Options Do We Buy?

As always, the first thing we analyze is the risk of the position. In strangles, your risk is limited to the price that you pay for the position. Hence, in this case, your maximum risk would have been $2.05 or $205 per contract. We could easily negotiate this rate down to $2.00 or less, which is where I like to keep my premiums for short term strangles.

Note that sometimes we can get away with using less expensive 30 day options provided that we know two things: First, we must have an event date within the 30 day period. This event may be an earnings report, an FDA announcement, or some big company announcement. If nothing happens on our expected event date, we absolutely exit the trade for whatever we can get as the IV will quickly drop in the case of a non-event. Second, we must have the discipline required to exit after a non-event.

What About The Stock?

Make sure when finding a large skew that there has been little to no recent movement in the stock. If there has been a recent move, then of course, there may be skew. We are trying to find opportunities before the fact, not after. Second, find out if there is a news event coming up. Pharmaceutical companies tend to have important upcoming announcements from time to time that are preceded by large IV skews. Given the quarterly nature of earnings announcements, unless there is a larger than average skew before the earnings report, chances are the earnings will be a non-event. Once we know when the news event will take place, it will be easy to decide on whether to use front month or second month options for the strangle.

A Few Final Words

Skew Finder is one of the most intriguing features in Optionetics Platinum. As traders, we must remember that our first concern is risk. Everything else is a distant second. While this tool can help us predict imminent breakouts in the stock. There is no such thing as a “black box” that actually works. However, for those of us that are Platinum subscribers, this tool can help us see the options order flow before an expected move – giving us a distinct advantage over those who choose not to invest in tools relevant to their trade.


Alex Mendoza
Contributing Writer and Options Strategist
Optionetics.com ~ Your Options Education Site

• Email This Article
• Print This Article
• Digg This
• Delicious
• Subscribe

Recent Articles by Alex Mendoza, Optionetics.com

• July 7, 2006
  Principles of Market Making
• September 1, 2004
  PLATINUM TOOLBOX: The Method of the Skew Finder
• March 31, 2003
  What Makes a Synthetic Straddle?
• February 14, 2003
  Put or Call? The Eternal Calendar Question
• February 12, 2003
  Dirt Cheap Winning Lottery Tickets