Basic pricing models, such as Black&Scholes, assume that volatility of the base asset remains constant throughout the life of the option and doesn't depend on the base asset price level. This contradics with the reality, where for most instruments volatilities tend to increase whenever the prices drop. In order to reflect this in option pricing volatilities for options of different strikes are taken as different, creating so-called volatility skew or volatility smile.
In this study there are positions in two out of the money options of equal value, which roughly cancel each other when the skew is zero and create non-zero expected payoff when there is some skew. You can also study the effect of the skew on any strategy by changing the model to Binomial Skew in Settings and editing the skew parameter.
Want to learn more? Download now an interactive reference application for iPhone.
The screenshot shows the following portfolio:
European put struck at 9.000 with expiry in 30 days
European call struck at 11.000 with expiry in 30 days
This is an excerpt from iOptioneer option trading reference application. In order to build the real-time dynamic strategy graph and run simulations you will need to download the application from App Store.