This summer, we focused on "volatility skew" and metrics such as "Put/Call Price Ratio" that can help us get better context on the degree of skew observed in the market at a given point in time.
Skew is an industry term which describes the fact that puts generally trade richer than calls, all else being equal. This phenomenon mostly occurs because of the risk of a "crash" (i.e. sharp selloff) in the broader markets, or in a particular underlying/asset.
By calculating the value of the 16 delta put versus the 16 delta call over time (the Put/Call Price Ratio), we can measure relative skew over time (for example in SPY). A previous episode of Market Measures detailed how the Put/Call Price Ratio can be computed in SPY, as well as how that data was used to generate a "Put/Call Rank" at tastytrade.
In short, the point of that exercise was to establish a baseline “fair” value for the Put/Call Price Ratio in SPY so traders would have a way of measuring the ever-changing degree of richness in puts over time (or at any given point in time). We recommend reviewing the aforementioned episode of Market Measures in its entirety for a comprehensive rundown on this methodology.
One important thing to keep in mind when talking about skew and the Put/Call Rank is the existence of "reverse skew." Reverse skew is typically observed when the market perceives more risk to the upside in a particular underlying/asset, as compared to the downside.
For example, gold prices are often viewed as more likely to "crash up" because gold typically gets a strong bid when other parts of the financial markets are going through bouts of heightened volatility.
To visualize this scenario, imagine global equity markets are in "correction mode" based on the belief that an economic recession is imminent. In this case, traders may adopt a strong conviction that gold prices could rise in the near future, and consequently bid up premium in the calls of gold-related names.
This is a perfect example of "reverse skew" (aka "upside skew), and we should add that it is usually observed in gold-related underlyings even in periods of relative complacency (just to a lower degree).
Traders need to be aware of reverse skew because trade ideas in underlyings that demonstrate upside skew may need to be evaluated in a different way than names exhibiting “normal” skew.
Recent research conducted by tastytrade illustrates, for example, that Put/Call Rank is less reliable as a trading indicator in underlyings that exhibit upside skew.
On the this newly released episode of Market Measures, the team conducted a study using both IVR and Put/Call Rank as a combined trading signal. The findings showed that the results of the trading approach were better when Implied Volatility Rank (IVR) was used a trading signal on its own, as opposed to an approach that used IVR and Put/Call Rank.
For more details on Put/Call Rank, and reverse skew, we hope you'll review the links below at your convenience:
If you have any questions about skew, "normal" or "reverse," we hope you'll leave a message in the space below, or send us an email at email@example.com.
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.
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