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I love to nerd out when it comes to options trading. |
After all, I built and ran education for thinkorswim and TD Ameritrade for 15 years. |
But what I'm about to share with you isn't some theoretical mumbo jumbo… |
It's a way to look at the options market, which will help you make better trading decisions. |
It's something the pros rely on constantly to gain an edge in the market…but something amateurs really think about. |
I know because I've observed several million retail trading accounts throughout my career. |
So What Am I Talking About? |
It's something called strike skew. |
You see, the way the options market works is simple. |
It's driven by supply and demand. |
If demand for an option is high, it becomes more expensive. If there is a lot of selling pressure in that option, it becomes cheaper. |
And all of this is reflected by the options implied volatility. |
That's why when you look at a set of options, you'll see that they don't have the same volatility. |
I'll show you how to analyze this strike skew to make better trading decisions. |
Types of Strike Skew |
Call Skew: |
Flat or Downward Slope: Implied volatility decreases as the strike price increases. This can indicate lower concern about large upward moves in the underlying asset's price. |
For example, let's take a look at Goldman Sachs, which is set to report earnings on Monday. |
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As you go farther out of the money on the call side you'll see how implied volatility decreases. |
So what does this tell me? |
Holders of the stock are likely selling OTM calls to hedge their position ahead of earnings. |
The option market is implying about a 4.5% move and based on the call skew it expects to fall within that range because there is no crazy demand for really deep OTM calls. |
Upward Slope Skew: |
Implied volatility increases as the strike price increases, reflecting greater demand for options and capitalizing on significant upward moves. |
Where do we see that? |
We actually see it in some Tesla calls right now. |
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As you go further OTM, implied volatility is rising. |
Speculators are trying to catch the move up and are willing to pay up for options. |
And because OTM options are more expensive from an implied volatility perspective, it makes it advantageous to trade strategies like debit spreads. |
If you own the stock and want to collect some income, selling calls can also be advantageous with this skew. |
Put Skew |
Volatility Smile: Implied volatility is higher for both deep in-the-money (ITM) and deep out-of-the-money (OTM) options compared to at-the-money (ATM) options. This creates a "smile" shape when plotted on a graph. |
We actually see this in Tesla put options right now. |
I know, there's a lot of action in Tesla, and we're seeing bets being placed on both sides. |
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Volatility Smirk: Implied volatility increases as the strike price decreases (for puts). This indicates higher demand for lower strike puts, reflecting concern about significant downward moves. |
And this is what we're seeing in NVDA options right now… |
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If you were bearish NVDA, buying a debit spread can be advantageous because you are selling the more expensive volatility. |
By the way, all these examples I'm showing are of options expiring next week. |
Does This Stuff Matter? |
If you want to graduate beyond the basics of trading calls and puts and want to be a more strategic options trader than yes. |
Armed with this knowledge, you'll be able to construct better options trades, which can potentially tip the scale in your favor. |
Of course, this is particularly as we head into earnings season. |
Oh… |
If you haven't watched a replay of my earnings presentation, make sure you do. |
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