ROBUST TRADING OF IMPLIED SKEW

Sergey Nadtochiy () and OBłÓJ Jan
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Sergey Nadtochiy: Department of Mathematics, University of Michigan, Ann Arbor, MI 48104, USA
OBłÓJ Jan: #x2020;Mathematical Institute, University of Oxford, Oxford, OX2 6GG, UK

International Journal of Theoretical and Applied Finance (IJTAF), 2017, vol. 20, issue 02, 1-41

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 one’s beliefs about the future values of implied skewness, which is an observable market indicator. As such, our method allows the use of existing statistical tools to formulate the beliefs, providing a practical interpretation of the more abstract mathematical setting, in which the beliefs are understood as a family of probability measures. One of the applications of the results established herein is a method for trading one’s views on the future changes in implied skew, largely independently of other market factors. Another application of our results provides a concrete improvement of the model-independent super-replication and sub-replication strategies for barrier options proposed in [H. Brown, D. Hobson & L. C. G. Rogers (2001) Robust hedging of barrier options, Mathematical Finance 11 (3), 285–314.], which exploits the given beliefs on the implied skew. Our theoretical results are tested empirically, using the historical prices of S&P 500 options.

Keywords: Implied skew; robust methods; weak reflection principle; LVG model (search for similar items in EconPapers)
Date: 2017
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Citations: View citations in EconPapers (1)

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DOI: 10.1142/S021902491750008X

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