Robust Trading of Implied Skew

TL;DR

This paper introduces a robust, model-independent method for trading based on implied skewness of options, allowing traders to form portfolios and improve replication strategies using observable market indicators.

Contribution

The paper proposes a new static portfolio construction method based on implied skewness, which is robust to model assumptions and applicable for trading and replication strategies.

Findings

Method is validated with historical SP500 options data.

Portfolio construction depends only on market-observable implied skewness.

Improves existing model-independent strategies for barrier options.

Abstract

In this paper, we present a method for constructing a (static) portfolio of co-maturing European options whose price sign is determined by the skewness level of the associated implied volatility. This property holds regardless of the validity of a specific model - i.e. the method is robust. The strategy is given explicitly and depends only on beliefs about the future values of implied skewness, which is an observable market indicator. As such, our method allows to use the existing statistical tools to formulate the beliefs, providing a practical interpretation of the more abstract mathematical setting, in which the belies are understood as a family of probability measures. One of the applications of our results is a method for trading views on the future changes in implied skew, largely independently of other market factors. Another application provides a concrete improvement of the existing model-independent super- and sub- replication strategies for barrier options, which exploits a given set of beliefs on the implied skew. Our theoretical results are tested empirically, using the historical prices of SP500 options.