Volatility - Option Valuation

Hello folks,

Joined this website today itself..I am bit new to trading. I have some basic questions regarding Option volatility...

While going through some literature about the valuation of option i came accross few jargons like 25 Delta Risk Reversal , 25 Delta Strangle and ATM volatility used for valuing the options. While these terms make sense taken in isolation, I am not able to interpret as a single term?
How should a trader reacts to it ?

A few questions regarding the same are -

Why these specific terms are used to measure the volatility? why not 50 Delta or any other strategy?

Are these the adjustment to volatility caused by volatility smile or skew OR these number signify something else?

How would a trader interpret these values ?

Are these numbers used in finding out the oppurtunity to do volatility arbitrage? If yes, plz quote some example...

Considering the content of this website which I have gone through, these questions sound a bit of basics..so spare me for that...

Thanks in advance...

These numbers are used to loosely parameterize the shape of the smile, predominantly in FX options. Specifically, people most commonly use the ATM vol, the 25d Risk Reversal (RR) and the 25d Butterfly (BF) to get an idea of the smile.

1) The reason why 25d is used, rather than 50d, is that 25d is sort of a useful out-of-the-money delta that people frequently trade.
2) These are not adjustments to volatility, but rather expressions for actual volatilities for different strikes. And yes, these are representations of the "skew" that volatility exhibits.
3) A trader can use these values to get an idea of what the smile looks like, in order to inform his/her trading decisions.
4) Volatility arbitrage is an often mis-used term. "Arbitrage" doesn't really exist in a majority of cases. You can use the numbers to come up with ideas about relative richness/cheapness of options. Trades to take advantage of these pricing idiosyncrasies are normally difficult, so most of the time the smile can just help with choosing what to buy/sell.

Hey thanks a ton for such a prompt and wonderful answer...
Few doubts still remain...
D answer of first question where you have stated about 25D out of the money option...can you state the same with some example and in detail?

You said its d volatility itself rather and not the adjustment for volatility...can you quote any interpretation giving some values..for eg. USDEUR June having 1.23% 25D RR and 1.50% 25D SR...what actually it conveys?
anything asked seems too basic to answer...pls bear with me..
Thanks again...!!

Firstly, take the ATM vol, as well as the vol of the 25% OTM call and the 25% OTM put. So let's take EURUSD as an example. Looking at the 3m options, I see smth like 10.4% as the ATM vol, 9.68% as the 25d call vol (strike 1.3587) and 11.78% as the 25d put vol (strike 1.2641). That puts the 25d RR at -2.1% (call vol - put vol) and the 25d BF at 0.33% ((call vol + put vol) / 2 - ATM vol).

I think the above should also answer your other question.

Hey..Just one request..could you plz interpret the RR & BF for trader...Just one two lines would be enough...

Well, I dunno... There's all sorts of possible interpretations and views and ideas that can arise from this. For example, if I observe that put skew is "expensive" (as is the case with EURUSD), I might decide that, if I want to do a bearish EURUSD trade, I shouldn't just buy expensive OTM puts outright. Instead, I might use the steep skew to do a put spread, which should be reasonably cheap. If I want to "fade" the steep skew, I might just decide to do a ratio put spread (e.g. a 1x2), although that sort of trade has a lot of other risks that one needs to be mindful of.

Thanks a ton...that was really of great help..