Traders inadvertently hurt their own results.
What is "skew?"
Skew measures the difference in implied volatility of three-month puts versus three-month calls, both of which are presently 10% out-of-the-money. Strictly speaking, "implied volatility" (IV) measures the expected price change of an underlying asset over a set period of time.
In recent years "volatility" has been used mainly to refer only to downside risk. Few traders complain about upside, even when it occurs rapidly.
Markets generally rise gradually but sell off abruptly. Why is that? It takes cash to buy stocks. Selling requires only a mouse click. You don’t even have to own the underlying index or shares first, if you are able and willing to go short.
Barron’s publishes charts of the SPX and NDX skews every weekend. SPX skew covers the large-cap broad market. NDX skew follows the tech-heavy Nasdaq stocks.
"Put" and "call" options are typically purchased by speculators and hedgers. Ownership of options allows for a leveraged, directional bet on the future price movement of an underlying stock, index or commodity.
Human nature leads individuals to trade badly most of the time. That is especially true when dealing with risky options.
A recent study showed that in falling markets, traders exhibit higher levels of the stress hormone (cortisol) which appeared to inhibit risk-taking. Higher skew readings indicate traders are feeling nervous. That is when they’re willing to pay up for put protection. That typically follows periods when the market has already sold off.
When skew is relatively low, calls are expensive relative to puts. "Bullish sentiment" is running high. Skew is a great contrary indicator. A glance at the last 12-months’ option activity clearly validates that assertion.
Times when the market was troughing, and should have been bought, are circled in red. Those were the exact periods when option buyers, as measured by skew, were piling into puts.
Conversely, in mid-May 2013, and again right at year’s end, the public was mainly buying calls. Again, they made exactly the wrong moves. Both periods came when the market was poised to retreat.
Making money in the market requires fighting your emotions. It is normal to feel the same fear as everyone else. It is not okay to trade like them.
About the author: