Podcast: Lorenzo Ravagli on why the skew is for the many

In his epic poem The Divine Comedy, Dante Alighieri combined the regional dialects of his time to create the modern Italian language, a unifying tongue that could be understood throughout the land.   

Fellow Florentine Lorenzo Ravagli, head of European FX volatility strategy at JP Morgan, jokes that his latest paper tries to do for volatility trading what Dante did for the Italian language, by proposing a unified framework for harvesting the skew premium in options. 

Ravagli presents a range of strategies for trading the skew premium, which is driven by the asymmetric pricing of out-of-the-money calls and corresponding puts. The simplest possible way of taking a view on the skew premium is through delta-hedged risk reversals, he explains. But the complexity of this strategy can increase significantly if traders consider more advanced sensitivities, such as the exact location of the strikes or the sensitivities of the maturities.

“Across different trading desks, [I found that] different people were using different metrics for proposing a tentative explanation of the P&L of a very basic skew position,” Ravagli says. This gave him the idea to propose a common standard: “I've tried to vulgarise some concepts that were somehow expressed in a very theoretical framework and bring them down to a language which could be accessible by a wider range of clients.”

In his paper, Ravagli introduces two theoretical – yet practical – concepts for unifying the different approaches to trading the skew premium. One links the first-order sensitivities of an option price to changes in the implied parameters, namely the value of the skew or the volatility of volatility. The other is a proxy expression for the vol of vol’s term structure. This curve is inverted so short-dated vol of vol is structurally much higher than longer-dated vol of vol. These concepts, Ravagli says, can allow traders to more accurately capture the P&L of an options portfolio.

Ravagli explains how to implement a risk reversal strategy to capture the skew premium. “A risk reversal is simply a position which buys a call and sells the put, or it does the opposite, depending on which of the two volatilities is higher,” he says. He also explains how to delta-hedge, rebalance, account for transaction costs and monitor the strategy over time.

Ravagli plans to conduct further research into this topic. One avenue that remains to be explored is the diversification effect such strategies could have on multi-asset, multi-strategy portfolios.

His unified framework for trading the skew premium could help popularise the strategy. But can it really compare to Dante’s masterwork? Let’s hope we don’t have to wait seven centuries to find out.

Index

00:00 Intro

01:30 The role of a quant strategist

06:00 The volatility skew

10:36 The theoretical innovations in skew trading

17:17 How to set up a skew trading strategy

24:57 Transaction costs and market impact

30:13 The skew premium in other asset classes

35:59 Skew strategies in a diversified portfolio

42:32 Future research

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