Reverse Skew: A Subtle Difference
Sep 25, 2018
By: Sage Anderson
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 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.
Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.
tastytrade content is provided solely by tastytrade, Inc. (“tastytrade”) and is for informational and educational purposes only. It is not, nor is it intended to be, trading or investment advice or a recommendation that any security, futures contract, transaction or investment strategy is suitable for any person. Trading securities can involve high risk and the loss of any funds invested. tastytrade, through its content, financial programming or otherwise, does not provide investment or financial advice or make investment recommendations. Investment information provided may not be appropriate for all investors, and is provided without respect to individual investor financial sophistication, financial situation, investing time horizon or risk tolerance. tastytrade is not in the business of transacting securities trades, nor does it direct client commodity accounts or give commodity trading advice tailored to any particular client’s situation or investment objectives. Supporting documentation for any claims (including claims made on behalf of options programs), comparison, statistics, or other technical data, if applicable, will be supplied upon request. tastytrade is not a licensed financial advisor, registered investment advisor, or a registered broker-dealer. Options, futures and futures options are not suitable for all investors. Prior to trading securities products, please read the Characteristics and Risks of Standardized Options and the Risk Disclosure for Futures and Options found on tastyworks.com.
tastyworks, Inc. ("tastyworks") is a registered broker-dealer and member of FINRA, NFA and SIPC. tastyworks offers self-directed brokerage accounts to its customers. tastyworks does not give financial or trading advice nor does it make investment recommendations. You alone are responsible for making your investment and trading decisions and for evaluating the merits and risks associated with the use of tastyworks’ systems, services or products. tastyworks is a wholly owned subsidiary of tastytrade, Inc (“tastytrade”). tastytrade is a trademark/servicemark owned by tastytrade.
Quiet Foundation, Inc. (“Quiet Foundation”) is a wholly-owned subsidiary of tastytrade The information on quietfoundation.com is intended for U.S. residents only. All investing involves the risk of loss. Past performance is not a guarantee of future results. Quiet Foundation does not make suitability determinations, nor does it make investment recommendations. You alone are responsible for making your investment and trading decisions and for evaluating the merits and risks associated with the use of Quiet Foundation’s systems, services or products.
Small Exchange, Inc. is a Designated Contract Market registered with the U.S. Commodity Futures Trading Commission. The information on this site should be considered general information and not in any case as a recommendation or advice concerning investment decisions. The reader itself is responsible for the risks associated with an investment decision based on the information stated in this material in light of his or her specific circumstances. The information on this website is for informational purposes only, and does not contend to address the financial objectives, situation, or specific needs of any individual investor. Trading in derivatives and other financial instruments involves risk, please read the Risk Disclosure Statement for Futures and Options. tastytrade is an investor in Small Exchange, Inc.