Does the Skew Index Have Predictive Value?
Jun 11, 2019
By: Sage Anderson
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 (of similar delta), then 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 trying to increase returns using the covered call strategy (a method of reducing cost basis).
You may have already noticed the existence of skew when reviewing the strikes in a given expiration month. If skew is "normal," you will see puts trading at a slightly higher implied volatility than calls, when looking at options with comparable delta.
Practically speaking, that means if you see the 20% OTM call trading for a lower absolute implied volatility than the 20% OTM put, it's not necessarily a "cheaper" option. Nor is the put necessarily the "richer option." Instead, this is often skew at work.
While it's important to be aware of skew, the degree to which a trader utilizes this metric often varies.
Strategies that rely heavily on quantitative analysis and/or engineering often track skew over time, and may use skew as an input in forecasts for “future volatility.” This type of approach attempts to account for fluctuations in skew and is included in a pricing analysis when deciding whether a given option is cheap, fair, or expensive.
For example, if skew is at the steepest levels observed in recent weeks/months, that may provide a trader with additional context on the relative attractiveness of a given opportunity.
For more information on this use of skew, we recommend reviewing a previous installment of Market Measures, “Should We Watch Skew?,” which highlights some powerful tastytrade research on the Skew Index.
As defined on that 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 research presented on the show leveraged internal tastytrade backtests that utilized historical data in SPY and the Skew Index. Basically, the analysis sought to better understand whether a short put in SPY performed better when sold in "all environments" or when the Skew Index was elevated.
According to that research, trade performance improved when the Skew Index was above 135.
For the sake of reference, the Skew Index typically ranges between roughly 100 and 150, as shown below:
Building on that previous research, a new installment of Market Measures takes a fresh look at skew, and the Skew Index.
In the new episode, the focus is on the predictive value of the Skew Index (i.e. do markets move more when the Skew Index is elevated). This exercise provides even more insight into skew, and how one might leverage it as a part of their overall strategy (or if).
The approach taken by the Market Measures team was to break down historical Skew Index data into four different categories - basically low skew trading environments, medium skew trading environments, high skew trading environments, and very high skew trading environments.
Next, they looked back at historical data in both SPY and VIX to see if any interesting patterns emerged - essentially to see if the Skew Index was successful at predicting movement (or lack thereof) in SPY and VIX.
Due to the complexity of the data and findings, we hope you’ll take the time to review the complete episode of Market Measures focusing on this topic when your schedule allows. In terms of a sneak peak of the results, let’s just say that the Skew Index may not be all it’s cracked up to be - at least in terms of its predictive value.
But, we can’t forget the earlier research conducted on Skew, which did show that short put performance improved when heightened levels in the Skew Index were used as a trading signal.
If you have any outstanding questions about skew, or want to share your experience using the Skew Index in your own trading strategy, don’t hesitate to reach out on Twitter (@tastytrade) or via email (firstname.lastname@example.org).
Thanks for reading!
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.
Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.
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