How Can We Interpret Volatility Skew & the Skew Index?
Feb 1, 2016
Disclaimer: You may become cross-eyed immediately after reading. But don’t worry, vision will return to normal after watching /ES futures for 2 minutes.
If you ever looked at a call and put the same number of points out of the money, you likely noticed either puts being more expensive than calls or vice-versa. This is known as “skew”.
More often than not, we see puts priced slightly higher than calls. There’s a reason the story of Chicken Little wasn’t about world peace or carb-free chocolate that doesn’t taste like a car tire. We humans are fearful of downside risk. We get scared when markets drop. The Skew Index helps us quantify chances the sky will actually fall and pull the market down with it.
The Skew Index measures perceived tail-risk in the S&P 500. Tail-risk refers to a change in the price of the S&P 500 or a stock that would put it on the far edges (tails) of the normal distribution. Those are the events that have really low probabilities. Except when they happen. Market volatility has not closed below 20 this year. That is a significant change from what we saw during most of 2015. Therefore, we asked cocktail party celebrity Dr. Data to break down this topic in The Skinny on Options Data Science: The Skinny Around Skew. The index measures the slope of implied volatility which can then be expressed as the probability of the S&P 500 making a two or even three standard deviation move over the next thirty days. Though we cannot actually trade skew as a product, we can use it in helping determine risk.
A typical range in the Skew Index is anywhere between 100 - 150 (don’t ask why or why my amp goes to 11 -- it just is what it is). Currently, the Skew Index is hovering a little over 129. At a reading of 130, there is approximately a 10% chance of the S&P 500 making a two-standard deviation move over the next thirty days. Chances of a three-standard deviation move are just 2%.
One shortcut for understanding how changes in the Skew Index translate to risk is this: each five-point move in the Skew Index adds or subtracts about 1.3 or 1.4 percentage points to the risk of a two-standard deviation move. A five-point move adds or subtracts approximately 0.3 percentage points to a three-standard deviation move.
Since we cannot trade this particular index, one way we here at tastytrade use the index is to increase general market awareness. As the slope of implied volatility moves higher, it pushes up the Skew Index. That lets us know the probability of a Black Swan event is increasing. It doesn’t mean it will happen or even that it’s likely. However, it is one more data point to help make us better, more informed, self-directed investors.
Josh Fabian has been trading futures and derivatives for more than 25 years.
For more on this topic see:
The Skinny On Options Data Science: The Skinny Around Skew January 28, 2016
If you have any questions about volatility skew, email us at firstname.lastname@example.org.
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