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Fatten up Your tail - Options Mastery Series Lesson 5

Filed Under General, Options Mastery Series 

Ron Ianieri, one of the founders of Options University and ex-market maker in Dell Computer, related a story about how to handle negative skew.  But first, what is negative skew?
 
You probably remember the standard bell curve for normal distribution. It looks like chart below.
insert fig1-1
Notice the symmetry on both sides of the mean. Under the regime of normal distribution, a trader could expect about one price move into the third standard deviation about once each year. For example, if the yearly price range for XYZ stock is $80-$160; about once each year the price might be down to $80 or up to $160 (white portion of the tails). But in reality, many volatile stocks may move more than 3 standard deviations more than the forecast 1-2% of the time. If this is done unevenly, the normal distribution will become skewed. In Ron’s case of Dell, much larger and more frequent price moves were to the downside. The distribution had a negative skew and looked like middle to the left.
insert fig5-2
As Dell had as many as eight three standard deviation excursions to the downside on the same year, Ron purchased many more out-of-the-money puts than out-of-the-money calls. He calls this compensation “fattening up the tail”, which in this case meant more puts (left tail) than calls in the right side of the curve. Of course the reverse is also true for a stock with a positive skew. In that case, the trader would fatten up the right side of the curve by purchasing more out-of-the-money calls. Additionally, on the side of the skewness, the price of puts or calls will be higher than on the non-skewed side. Another way to look at it is that if you expect more of a possibility for large moves to the downside, you would want your OTM puts to be more expensive than comparative OTM calls.
 

This is different than positive or negative put-call skew because this term refers to corresponding options (put and call volatility at the same strike price). This pertains to one particular option whereas positive or negative skew refers to the distribution itself. If there is more of a probability of large downside excursions than upside, it is negative skew; more probability of moves to the upside would be positive skew. When playing the probabilities, a trader might consider a heavier weighting of OTM puts for negative skew and the reverse for OTM calls for positive skew.

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