Tom Sosnoff's Volatility Skew Trading: Exploiting Imbalance in Option Prices

Tom Sosnoff actively trades volatility skew. He understands that implied volatility is not uniform across all strike prices. He exploits these imbalances. He sells overpriced options. He buys underpriced options. This creates a structural edge.

Understanding Volatility Skew

Volatility skew describes the difference in implied volatility for options with the same expiration date but different strike prices. Equity options typically exhibit a 'smirk' or 'skew.' Out-of-the-money (OTM) put options often have higher implied volatility than OTM call options. This reflects demand for downside protection. Traders pay a premium for insurance. Sosnoff recognizes this market inefficiency. He knows that OTM puts are often 'richer' than OTM calls. He uses this knowledge to construct trades. He also observes how skew changes. Earnings events or market crashes can alter the skew significantly. He adapts his strategy to current market conditions. He does not assume a constant skew profile. He measures implied volatility percentiles. He compares current implied volatility to historical levels. He seeks options where current implied volatility is in the upper quartile of its historical range.

Strategies Exploiting Skew

Sosnoff constructs trades to exploit favorable skew. He often sells OTM puts. He sells premium where implied volatility is highest. This allows him to collect more credit. For a bullish outlook, he might sell a put spread. He selects a strike price with elevated implied volatility. For a bearish outlook, he might sell a call spread. He looks for call options with higher-than-average implied volatility. He uses iron condors to exploit skew across both calls and puts. He sells the OTM put and call wings. He buys further OTM options for defined risk. He adjusts the strike prices to take advantage of specific skew profiles. He may sell a put spread that is further OTM than a call spread. This biases the trade to the upside. He seeks a higher probability of profit. He uses a similar approach with iron butterflies. He sells the at-the-money (ATM) options. He buys the OTM options. He adjusts the wings to benefit from skew. He aims for a positive theta. He wants time decay to work in his favor. He avoids strategies that are negatively impacted by time decay unless he has a strong directional conviction.

Trade Construction and Adjustment

Sosnoff constructs skew trades with precision. He targets specific delta values. For selling OTM puts, he looks for a 10-20 delta. This gives a high probability of expiration out of the money. He monitors the implied volatility of his strikes. If implied volatility drops significantly, he considers closing the trade. If implied volatility rises, he may hold or adjust. He aims for a credit received that is sufficient to cover potential losses. He uses a credit-to-width ratio. For example, on a $5 wide put spread, he targets a credit of $1.50 or more. He defines his maximum loss. He adheres to his risk parameters. He adjusts trades when skew shifts unfavorably. If the implied volatility of his sold option drops, he might roll the position. He rolls to a further expiration or a different strike. He only rolls if it improves the risk/reward profile. He does not roll to chase losses. He maintains a disciplined approach. He closes winners at 50-75% of maximum profit. He closes losers at 1.5-2 times the initial credit. He does not let emotions dictate his trading decisions.

Skew and Market Environment

Sosnoff understands that skew changes with market environment. In bear markets, put skew often increases. Demand for downside protection rises. In bull markets, call skew can increase, but less dramatically. He adapts his skew strategies accordingly. During periods of high volatility, the entire volatility surface shifts up. This presents opportunities to sell premium across the board. During periods of low volatility, options are cheaper. He may consider buying options for specific directional plays. He always considers the current VIX level. He assesses whether options are generally rich or cheap. He prefers to sell options when implied volatility is high. He uses tools to visualize the implied volatility curve. He identifies dislocations. He makes informed decisions based on data. He does not guess. He maintains a systematic approach to exploiting volatility skew. He understands that small edges, consistently applied, lead to long-term profitability.