Skew is an important concept in the world of options and although it may sound complicated, it's fairly straightforward.
If you've ever noticed that downside puts are almost always more expensive than upside calls, you've officially observed skew in the options marketplace.
Skew exists because many market participants live in fear of a crash in prices. As a result, there are natural buyers of downside puts (insurance), which contributes to an inflation in premiums.
Upside calls, on the other hand, are relatively less expensive because there are natural sellers of these options - particularly sellers of upside calls trying to increase returns (also referred to as lowering cost basis).
While a general understanding of skew can certainly help option traders optimize position structure at the symbol level, there are other applications of skew at the market level.
If you want to learn more about skew, a recent episode of Market Measures provides additional context on how skew observations can help uncover potential trading opportunities in your portfolio.
As outlined on the show, the CBOE Skew Index (ticker: SKEW) measures the probability of outlier returns in the S&P 500. The index rises when downside put buying activity intensifies - signaling a growing expectation for a big move in the market.
The chart below illustrates how the CBOE Skew Index rose rapidly into the "Brexit" referendum as expectations increased for a significant aftershock:
The Y-axis on the chart above plots the value of the CBOE Skew Index from early 2015 to present and helps illustrate the historical range of the Index - which is roughly between 100 and 150.
The lower end of the spectrum (100) corresponds to almost no expectation for an outsized move, while the higher end (150) suggests traders are preparing for a big move.
It's important to note that the CBOE Skew Index is only an indicator of trading activity/trends, and not a forecast of market movement. Market-wide expectation of a big move doesn't mean that traders will be right.
Because a high reading in the Skew Index (ticker: SKEW) means that put premiums are rich, the Market Measures team decided to run a study analyzing the success of selling such options during these periods.
The study involved selling 45 days-to-expiration 30-delta puts in the SPY and comparing three scenarios (using data from 2005 to present):
Selling in all environments
Selling only when SKEW > 125
Selling only when SKEW > 135
The results of this particular study may come as quite a surprise to many. Over the timeframe included in the data set, the performance of short premium puts sold when the SKEW Index was over 135 actually outperformed the other two scenarios investigated.
The absolute credit received during these high levels in SKEW may have translated to higher premiums, contributing to the higher returns. However, what was also surprising about the results when SKEW was greater than 135 was the fact the largest loss was also reduced (versus the other two scenarios).
We think this material is important enough to warrant a full review and we hope you’ll take the time to watch the full episode of Market Measures focused on market skew when your schedule allows.
A previous blog post covering skew may also be of interest.
If you have any questions or comments on this topic please don’t hesitate to reach out at firstname.lastname@example.org.
We look forward to hearing from you!
Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.