How Can We Interpret Volatility Skew & the Skew Index?
Feb 1, 2016
By: Josh Fabian
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 email@example.com.
Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.
Aug 30, 2017
Instead of going through different positions and strategies to figure out which way you need the market to go to make money, delta will give you a snapshot of this information for each position, strategy, and even your overall portfolio. On the simplest level, delta (positive or negative) tells us which way we want the underlying to go to make money.
Jun 23, 2017
In options trading, the term 'in the money' is used quite often to describe the position of an underlying in relation to the strike price of a stock option. For experienced traders, the term 'in the money' is inherently understood, however for newer traders or investors learning how to trade options, this term can be a bit confusing.
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.