Question

Volatility skew/smile and gamma are both volatility-oriented strategies. Compare and contrast the two trading strategies.

Answer 1

A volatility smile results from plotting the strike price and implied volatility of a group of options with same expiration date. The more the option is in the money or out of the money, the greater its implied volatility becomes.

In Gamma trading you can take two positions : Long gamma and short gamma. In long gamma, you make profit when realized volatility is greater than implied volatiltiy of the purchased option and in short gamma , profit is made when realized volatility is less than implied volatility of purchased option.

A Volatility trader profits from rise in VEGA (measures sensitivity of stock price to change in implied volatility) through delta neutral positions on long term options.

A gamma trader trades the directional volatility of the underlying while the volatility trader trades the volatility of implied volatility of the underlying.

Volatility smile is used for number of investments, it cannot be observed in over the counter foreign exchange markets though investors can use at the money call volatility and risk data to create a volatility smile and gamma traders mostly trade short dated options whereas volatility traders mostly trade longer dated options.