Thursday, April 02, 2015

What We Can Learn From Options Skew

Above is a chart of CBOE options skew for the S&P 500 Index from 2014 to the present.  The skew index measures the degree to which index options traders are bidding up out of the money puts relative to calls.  The index moves between 100 and 150, with 100 meaning that traders are not pricing in negative tail risk and 150 reflects a high degree of negative tail risk pricing.  This can be viewed as a sentiment index, as it reflects the degree to which traders are hedging against market risk.

Interestingly, we've tended to see low skew numbers near intermediate term lows in SPY and high skew number near intermediate-term tops.  This is different from what we see with put/call ratios.  Here we see a higher degree of tail risk hedging following strength rather than weakness, perhaps as a strategy to lock in gains.

I divided the sample into quartiles.  When the skew has been in its highest quartile, the next ten days in SPY have averaged a loss of -.76%.  When skew has been in its lowest quartile, the next ten days in SPY have averaged a gain of +1.14%.  The most current skew reading is in the lowest quartile.

I will be refining this measure and looking at a longer history in the near future.  It appears to be a worthwhile complement to other sentiment measures.

Further Reading:  Equity Put-Call Ratio