• C++ Programming for Financial Engineering
    Highly recommended by thousands of MFE students. Covers essential C++ topics with applications to financial engineering. Learn more Join!
    Python for Finance with Intro to Data Science
    Gain practical understanding of Python to read, understand, and write professional Python code for your first day on the job. Learn more Join!
    An Intuition-Based Options Primer for FE
    Ideal for entry level positions interviews and graduate studies, specializing in options trading arbitrage and options valuation models. Learn more Join!

Question on Barrier Option and Skew

Joined
11/3/13
Messages
6
Points
11
If you bought an Equity Call Option with a Down-and-In Barrier, are you Long Skew or Short Skew? Please provide explanation as well. Thanks.
 
If you bought an Equity Call Option with a Down-and-In Barrier, are you Long Skew or Short Skew? Please provide explanation as well. Thanks.

Long
You want the option to knock in, and want vol to be high when it knocks in as you will be long a vanilla call option a that point. Put together, your vega profile across spot will increase as spot moves down toward the barrier level. This means you are synthetically long low strikes, making you long skew (assuming that the smile in the underlying is bid for puts). Additionally, once this option knocks in, the call you will be long will be a high strike relative to the at-the-money point, so you will knock into a long high side vega position once the barrier event happens. This implies you are also long flies on the underlying. This also means that in the blended local-stochastic vol model, you want your blending factor to weight the stochastic vol process over the local vol process, because in the local vol process the high side vega you will be long will be worth less as the risk reversal will grow larger in favoring puts over calls with a move lower in the underlying (in the stochastic vol process, the risk reversal would remain constant). So you also have exposure to the model dependent greek which controls how stochastic vol and how local vol your process is.
 
Long
You want the option to knock in, and want vol to be high when it knocks in as you will be long a vanilla call option a that point. Put together, your vega profile across spot will increase as spot moves down toward the barrier level. This means you are synthetically long low strikes, making you long skew (assuming that the smile in the underlying is bid for puts). Additionally, once this option knocks in, the call you will be long will be a high strike relative to the at-the-money point, so you will knock into a long high side vega position once the barrier event happens. This implies you are also long flies on the underlying. This also means that in the blended local-stochastic vol model, you want your blending factor to weight the stochastic vol process over the local vol process, because in the local vol process the high side vega you will be long will be worth less as the risk reversal will grow larger in favoring puts over calls with a move lower in the underlying (in the stochastic vol process, the risk reversal would remain constant). So you also have exposure to the model dependent greek which controls how stochastic vol and how local vol your process is.


Thanks financeguy!!!

Think I understand now. If spot moves down towards Knock-In Barrier, I want high vol (to knock the barrier). Therefore, I'm long low strike (long skew).

Just to make sure that I understand this concept fully:

Down-and-In Barrier Option = Long Skew
Down-and-Out Barrier Option = Short Skew
Up-and-In Barrier Option = Short Skew
Up-and-Out Barrier Option = Long Skew

I think I got it right, right?
 
Thanks financeguy!!!

Think I understand now. If spot moves down towards Knock-In Barrier, I want high vol (to knock the barrier). Therefore, I'm long low strike (long skew).

Just to make sure that I understand this concept fully:

Down-and-In Barrier Option = Long Skew
Down-and-Out Barrier Option = Short Skew
Up-and-In Barrier Option = Short Skew
Up-and-Out Barrier Option = Long Skew

I think I got it right, right?

Yes basically right, and those identities are generally correct. Bear in mind it's really about the vega profile across spot. So for barrier options that knock in or out when the option is in the money, when spot gets sufficiently close to the barrier, it's more about delta and less about vol, so the peak of the vega profile actually will be on the opposite side of spot as the barrier - and so the skew position will flip the other way around.
 
Back
Top