Trading Skewness and Kurtosis

1 Introduction
The trading strategies described here are not risk-free arbitrage trading
strategies.1 They are based on the belief that option is over- or under-
priced compared with the stock market prices or ones expectation about
the future. In particular, the trading strategy is based on the divergence
between the risk neutral distribution implied from option prices and ones
expectation or the real distribution of the underlying stock.
If the real distribution is lognormal, then the change of measure means
the shape is preserved when we shift to the risk neutral distribution. So if
the option price produces a BS implied volatility skew, it means the OTM
put is over priced. Such an analysis cannot apply straightforwardly to
other stochastic processes however. For example, given Heston dynamic
and negative correlation between stock price and volatility, we could expect
to see a volatility skew anyway even when the options are correctly priced.
In this case, we would want to wait till the risk neutral distribution is more
skew than expected before executing the same type of trading strategies.
While the illustration below is based on SPX options and the real distri-
bution of S&P 500, the idea can be extended to any other types of options
including the VIX option and option on correlation bearing in mid that the
key foundations of all trading strategies is based on the divergence between
real and risk neutral distributions.

2 Skewness Trade
When the risk neutral distribution is more negative skewed than the real
distribution, this means OTM put (at low strike) is potentially overpriced,
and OTM call (at high strike) is underpriced. So the strategy is to sell put
and buy call. The portfolio should be vega neutral in order for it to be
immune to parallel shifts of the volatility level. Since the vega of a call is
usually not the same as the vega of a put, both vega and delta of call and
put are needed for constructing a delta-vega-neutral portfolio as follows:

c c
= c (St ; Kc ) p (St ; Kc ) c p St
p p

and since these greeks are correct only for small changes, the position should
be dynamically adjusted. But, in practice the frequency of rebalancing has
to take the level of transaction costs and bid-ask spreads into consideration.
1
Much of the materials here is extracted from Javaheri Alireza (2005) Inside Volatility
Arbitrage: The Secrets of Skewness, Wiley Finance.

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 Since p increases more steadily than c when St decreases (and vice
versa when St increases), the skewness trade has an exposure to the direction
of the markets. A bullish market is favourable to it, and a bearish one
unfavourable.

3 Kurtosis Trade
If the risk neutral distribution has a much higher kurtosis than the real
distribution, then one may attempt to sell OTM options (call and put) and
buy ATM or near-the-money (NTM) options. If we use K1 , K2 and K3 to
denote the strike prices with K1 < K2 < K3 , the delta-vega-neutral portfolio
may be constructed as follows:
c3
= c (St ; K3 ) p (St ; K1 )
p1
c2
+c (St ; K2 ) + p (St ; K2 )
p2
c3 c2
+ c3 p1 + c2 + p2 St
p1 p2

The kurtosis trade is like a buttery trade, it generates a prot if the market
stays within a narrow range near St , but loses money if there are large
movements.
The kurtosis trade could also be replicated by the classic buttery con-
structed from long one call each at K1 and K2 , and short two calls at K2 .
Alternatively, one could also long one put each at K1 and K2 , and short
two puts at K2 . These positions should also be delta hedged by having
appropriate exposure in St .

4 Option expectation and mirror trades

The skewness and kurtosis trades are often interpreted as insurance selling
strategies. If the market has a crash, the skewness trade will suer huge
losses. Similarly if the market has a large swing on either up- or down-side,
the kurtosis trade will lose money. In practice, the skewness trade seems to
be a simpler one and has a better chance of being materialised. To produce
a large skew, one would need a large vol-of-vol and a negative correlation
between stock return and volatility (or a crash). The historical data (real
distribution) tends to have fat tails but relatively symmetrical, whereas the
risk neutral distribution tends to have fatter left tail. This is why it is
more likely to have a protable skewness trade opportunity even when the
kurtosis trade opportunity is not available.
Should one see the opposite conditions in the market, one could obviously
put on the mirror trades (i.e. buy skewness and kurtosis through options

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instead of selling them). The mirror trades could be considered as buying
insurance and protecting oneself against a possible crash or a large market
movement.

5 Practical issue in setting up a trade

First of all, one should remember that we buy at the (higher) oer
price and sell at the (lower) bid price. In testing strategy, one may
choose to omit the bid-ask spread momentarily but to check that the
prot per round-trip trade is larger than the bid-ask spread.

The prot and loss (P &L) should include the appreciation/depreciation

of the hedge instrument as well as interest charge/earned on the cash
decit/surplus over the holding period.

Some strategies (especially those centred on European option relation-

ship) are designed for holding till option maturity. However, we may
want to consider unwinding the position before maturity. Indeed, as
we get closer to maturity, our hedge ratio might get closer to one,
which makes the hedge account extremely sensitive to adverse stock
movements. This early unwinding (instead of holding the position till
maturity) means another round of bid-ask spread cost.

Which volatility (implied vs. historical) should one use in the calcula-
tion of the hedge ratio? Our trading strategy is based on the premise
that option implied volatility (or option price) is wrong vis-a-vis the
real (historical) volatility. However, using the implied volatilities in
hedge ratio makes practical sense because they are the ones that drives
market option prices. Using the historical volatility will create a mis-
match in terms of mark-to-market value with the existing option levels
in the market.

As mentioned before, selling skewness is like selling insurance. If there

is a strong vol-of-vol and negative correlation between price and volatil-
ity, such a trade will not be protable. In the case of pennystocks,
volatility tends to rise when stock price increases as these stocks come
back to life. This means a positive correlation and a protable trade
for selling skewness. However, since the penny stocks are high risk
stocks, the possibility of a crash is non-negligible, and that is possibly
what causes the option implied skew in the rst instance!

The same analogy applies to index option. The index option should
have less skewness due to diversication. However, the empirical styl-
ised fact is that correlation among all stocks tend to rise during severe

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market down turn. This expectation will result in a longer left tail in
the index option implied risk neutral distribution.

Detecting an inconsistency between the stock and option markets (es-

pecially if based on historical information) are not su cient for making
protable trades. What is more important is the future expectation.
In this regards, it is not su cient just to look at the current and histori-
cal information of the stock market because option prices are reection
of future expectation between trade date and option maturity.