Hey guys,
I had a hard time understanding the Volatility Skew and Volatility Smile content that is written in the Schweser notes, because its written in a way that confuses more than educates, and seems to assume you know a lot already about what the author is talking about.
For my revision, I modified the explanation of a volatility skew, smile and risk reversals but I just wanted to know from y’all whether I’ve made any mistakes in my understanding:
You can draw conclusions on market sentiment when the volatility skew deviates from historical levels:
⦁ A sharp increase in the level of the skew implies that market sentiment is bearish because increased demand for OTM puts as insurance against market declines is causing their prices (and hence, implied volatilities) to go up.
A surge in the absolute level of implied volatility is also a bearish signal.
Level of skew decreasing:
*Higher-than-normal implied volatilities for OTM calls indicate that investors are turning bullish, because the higher implied volatilities are caused by the demand (and thus, the prices) of these OTM calls going up - and that’s due to increased interest to take on upside exposure.
Deviations such as these that are expected to correct could form the basis of trading strategies known as risk-reversals:
1. A long risk reversal combines long calls and short puts.
The trader expects the increased skew to fall back down to normal levels. Hence, buy the under-priced calls and sell the over-priced puts.
2. A short risk reversal combines short calls and long puts.
The trader expects the decreased skew to go back up to normal levels. Hence, buy the under-priced puts and sell the over-priced calls.
Is what I wrote all correct?
Thank you so much,
Regards