Trading Inverted Implied Volatility Skew with Vertical Call Spreads
A discussion today on Twitter led me to thinking this could be a helpful topic to discuss…
It is Friday, so will keep this short, and hopefully sweet.
I often will note “inverted” or “bullish” skew when discussing a stock’s options IV (Implied Volatility) profile. I do not want to get into a deep explanation of the concept as it is readily available with a simple Google search. It is one of the more important concepts in options trading, and suggest diving into the topic deeper.
Basically a normal IV Skew reflects higher IV in the OTM puts compared to the ITM Calls/Puts and OTM Calls, sloping down from left to right as strike prices increase. The reason for this is that the need for protection via puts drives up demand of OTM puts with the natural market long bias in stocks, and there are some other explanations as well, but that is the simple conceptual view and without being too mathematical and the takeaways are more important.
There are occasions, fairly rare, where the IV Skew inverts, also called a bullish IV skew and often referred to as an IV “smile”. What this is showing is an upside bias as the demand for OTM calls is so strong that the IV profile “flips” and the demand for OTM puts is weak, so longs see limited need for protection, a view of limited downside with a strong bias towards an upside stock move.
A recent case of this for August was in Anadarko Petroleum (APC) where the IV Skew inverted with strong demand for the OTM calls, seen ahead of its 7-30 earnings date, though the Institutional sized traders in the calls looked to be expecting an additional catalyst such as the litigation with Tronox (TROX) or drilling results. You can see the August OI as of today in the $92.50 calls was 22,991 and 42,130 in the $95 calls, each of which expired worthless, which brings me to the important takeaway.
Conceptually the activity is implying a view shares will close that expiration above the given strikes being bought, and this IV driven higher in the contracts. However, my takeaway with this is that if the expectations are for that kind of move the higher probability trade is utilizing vertical call spreads that will not offer the same kind of returns as striking gold in the OTM calls, but is a more intelligent way to trade.
In this case the trade was to be buying the “cheap” (in relative IV terms) $87.50 calls, and sell the “rich” (again, in IV terms) $92.50 calls. The APC August $87.50/$92.50 call spread was available for less than $2 into earnings and closed today just above $4, a 100% gain, and clearly the better trade than being long the OTM calls that expired worthless, or even the stock itself.
This is my preferred method, while another strategy would be to put on calendar call spreads, selling the front-month OTM calls that are “bid-up” (meaning bullish IV skew profile), and buying the next month ITM or OTM calls that are cheaper in IV terms, a calendar or diagonal spread. The issue with this strategy arises if the positive catalyst comes in the front-month before expiration and blows through the upper boundary of the profit zone.
We recently applied the vertical call spread strategy in Family Dollar (FDO) that was exhibiting a bullish IV Skew, well ahead of the recent takeover chatter, and put on August $70/$75 call spreads for $0.60, and were pricing above $3 on the recent spike, a quintuple.
Now, if you made it this far I hope you enjoyed the article, and as a reward a case of IV Skew inverted for September that looks unusual is in Qlik Tech (QLIK), where a strategy such as the September $33/$37 call spread at $1 debit makes a lot of sense for a 3:1 reward/risk, and a name that has been trading very well and can be a candidate for M&A.