John,

A question on volatility skews. Do they make a difference on out of the  
money credit spreads?

For example, if I enter a slightly out of the money credit spread, what  
difference does it make what the volatility on the options are? I know my  maximum
financial risk and gain ahead of time, assuming I don't roll in and out  of
the spread before expiration. And assuming the spread expires out of the  
money, I've made my profit.

I can see that the overall volatility of the underlying would make a  
difference, since I could more easily find the spread being in the money at  
expiration on a highly volatile stock.

What am I missing on this?

Thanks,

Jim

Hi Jim,

It makes a difference because it will determine the amount of credit
you receive.  The sharper the skew, the more the credit.  Also, the
sharper the skew, the less risk you are taking on the vertical.

For example.  Stock is at 97 and you sell the Dec 100 call and buy the
Dec 105 call for a 1.00 credit.  Now if the stock moves against you,
because of the steepness of that skew, you might be able to get out of
this spread with minimal loss because at 100, the Dec 100 call will now
be ATM and may have a substantial drop in implied vols.  Now, the
position still carried short deltas, however, you will lose less money
then you would if you sold into a neg call skew where the vol would
actually INCREASE going into the ATM strike.

Now, you might think these are all petty details, I assure you they are
not.  Like I mentioned at the last meeting, these nickels and dimes do
add up at the end of the year, and for most traders, they make the
difference between making money on the year and losing money.

I understand the idea of looking at your risk from the standpoint of
max loss on the dif between the strikes, minus the credit.  But a
trader should NEVER take the max loss on any position.  That is why you
trade, to avoid that scenario.  You manage the risk to minimize the
losses.  You just don't accept the max loss.  That is throwing away
money.  

John

First time on this site, so I am not certain this is the right spot for
my response.  Response of subsequent trader was fairly well on the
money.  I would like to give you a complete answer about skew, as I am
the individual who was probably the first person to identify skew and
to quantify & apply skew analytics.  Hard to believe, but there is
usually a "first" person.   And here is where the other response is not
completely correct: the varying degrees (positive dollar amounts) to
which the spread can be done as or for a credit, does not necessarily
correlate to the odds that the spread in question will be more or less
successful (profitable) relative to the dollar amount.  Skews are, in
fact, symptomatic of the markets in more "efficient" market-making
scienarios, and you can be sure the locals have a valid sense of where
the probabilities should be.  One other point differing from the other
response to your question: trading out of spreads is not necessarily a
"good thing"...you should have executed the spread because that is
either your trading schtick/style and/or because you had a perceived
"edge" (thought the measured skew was in your favor to take on)...to
change your shtick, in a general sense, on the way out (closing) the
trade may be taking on a whole other risk profile, not necessarily
advantageous to developing your trading niche.  This is all a big, big
subject...and the other responder did a very good job in answering your
question.