Relative value volatility trading refers to trading volatility using opposite legs of some financial instruments, such as options, to take advantage of the movement in volatility. Usually, one would initiate a trade with a long call and a short call, forming a two-legged trade. There are a lot of variations to these types of trades, and we will mainly look at trading the slope of the volatility smile using options. This will form the basis of the trading strategy used in this book.
First, we'll recap Chapter 6, Exploring Volatility, where we looked at the smile effect for options on the OMX exchange in Sweden. The volatility smile is a phenomenon observed in stock markets. The smile is obtained by plotting the implied volatility from the options on the y axis and moneyness on the x axis.
Moneyness is the ratio between the spot price of the underlying asset, S, and the strike price of the option, K:
In the following screenshot...