my aversion to trading implied skew

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Here’s a question that was posted in the community this week:

I was reading thru an old tweet of yours on trading skew. The tl;dr of the tweet was don’t trade skew… Given I am in a masochistic mood, how would one go about backtesting a skew trading strategy?

I had 2 ideas, which I’d love to get your thoughts on.

Idea 1:

1. X asset 25d 3M normalized put skew is in the 100th percentile, sell a 25d put strike, delta hedged
2. hedge the delta daily or at some discrete interval
3. check how this strat would have performed assuming the trade is held until expiry

Idea 2:

1. X asset 25d 3M normalized put skew is in the 100th percentile, sell a 25d put strike, delta hedged
2. wait until normalized skew returns to some threshold, for example 75th percentile
3. hedge the delta daily but close out the trade as soon as the threshold is hit

Lots of questions, but the main ones are:

1. for idea 1, does your pnl depend on implied skew vs realized skew (similar to implied vol vs realized vol). How would you measure this?
2. for idea 2, does your pnl depend on a combo of realized skew (for as long as the trade is held) as well as surface repricing (ie selling at 100th percentile implied skew and closing out at 75th percentile). The thought of measuring this gives true masochists vibes, but how would you?
3. I wonder if the juice is worth the squeeze? Meaning, assuming you built the foundation to measure/test all the above, is there really any pnl in it / are you better off focusing on VRP trades?

My response:

As a matter of practicality, I think the test should be more in the vein of idea #1.

If you consider skew percentiles, the difference between the the 25th and 75th percentile could be some absolutely small number like 2 vega points. And the level of skew itself measured by percentile is sensitive to the percentile lookback such that the range you are trading over is just quite small. Your interim p/l will be the sum of implied vol change but plus realized delta hedging p/l.

But consider this…let’s say you sell the 25d put and it becomes a 50d put but the skew normalizes. That skew metric is no longer referencing your position. You have a floating vs fixed problem. In other words, you can’t really trade implied skew directly.

Your results are basically going to come down to path. Your interim p/l is going to get marked based on the IV of the fixed strike you have on and that in turn is going to influence the delta you hedged on.

The delta you hedge on is going to have a large impact on your final p/l so it’s not just where does the stock go but what deltas were imputed along the way. For example suppose you run a model with spot/vol correlation embedded in the SP500…this will generate higher OTM put deltas.

If the market trends down you will win to this but vice versa. However, if you used B-S deltas you will get hurt as the market goes down and vice versa. And even then, you will def get hurt on the marks, but if the stock expires near the short strike you will probably still win by expiration even though the mark-to-market path is hairy.

I used to work with a big oil options trader that would on a monthly basis stick a hedged 1-month risk reversal in a separate account and hedge it on B-S deltas. My point is that is an active choice that influences the results. Another choice could be to hedge on deltas that don’t incorporate implied skew at all but just use ATM vols.

Overall, testing the idea, even a monte carlo, is a great way to get a shape of the problem but more importantly because you can see how the parameters you choose impact the p/l path.

I’m not kidding when I say skew trading is masochism. If oil is $75 and has massive put skew and the market drifts down to $55 and the skew gets hammered (so say the 40 puts don’t perform) but you sold the 60 put what skew did is irrelevant. All that will matter is how fast did the stock go to $55 and what deltas were you running on the $60 strike along the way.

The weirder the distribution the crazier this is. I’ve seen nat gas option traders blow out being long put skew on a 15% drop in the underlying because they used too high of an implied option delta and they delta hedged several times on the way down.

Had they they run a lower vol and delta OR hedged less they might have survived. There’s not much lesson from this other than…sometimes a 15% selloff is interpreted by the market as “stabilizing” and sometimes it’s destabilizing and that is what’s gonna dictate the options behavior.