David Varadi at Blue Sly Asset Management put out a
good post on skew as an indicator of tail risk. He put some good analytics behind it. For a long only investor I can see that rising skew could be a bad sign or as he puts it "Skew is a measure of the upside versus downside potential for a given market. Mathematically, negative skew is associated with higher tail risk while positive (or less negative skew) is associated with lower tail risk...Our analysis shows that the CBOE Skew Index is a useful indicator for assessing market potential for up to two and a half months following new highs or new lows. New highs tend to predict below-market returns while new lows tend to predict above-average returns for up to 50-days later. However, more data is needed to determine whether the CBOE Skew Index is an effective predictor of tail risk events."
On the other hand, I sell options and negative skew generally means, in addition to maybe heightened tail risk, that premiums are probably high to the down side in the options market. Skew and vol are different moments of a distribution but high skew says that the volatility risk premium, theoretically and empirically proven to have a legit positive return expectation (AQR has a good link on this somewhere), is begging to be sold. Lets take a look at April ES mini futures options:
Red is a skewless proxy for price probability using a rule of thumb. The blue line is a custom function of put and option premiums that shows some insight into options pricing based skew. The blue bars are the premium per contract in dollar terms, puts to the left, calls to the right. The green is the current deltas under 10. Red dot is current price. Dotted lines are +/- 1 and 2 stdev with respect to the red line.
Yup, big fat premiums to the left. Not infinite but some opportunity. So which is it? Sell puts (long bias), go short the market, or do nothing? I think do nothing. Trump is doing to the market what the Fed used to do. I didn't like the latter and I don't like the former. But the market does look like it's bent right now. Maybe next week...
see also
The Risk of a Crash Has Never Been Higher? March 20th, 2017 Charlie Bilello
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