Paul discusses the propensity for traders to screw or “skew” themselves, sabotaging their performance by allowing their emotions to interfere with their judgment. Understanding an indicator called “skew” is one step towards trying to avoid a common mistake. ~ Ilene
Stop Skewing Yourselves
By Dr. Paul Price of Market Shadows
What is skew?
Skew measures the difference in implied volatility of 3-month puts versus 3-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. Because stock markets generally rise gradually but sell off abruptly, volatility is more closely correlated to downward movements than upward action.
Why might that be? It takes cash to buy stocks. Selling requires only a mouse click. You don’t have to own the underlying index or shares to sell them, you don’t have to have the cash.
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 behavior. Higher skew readings indicate traders are feeling nervous. That is when they’re willing to pay up to own put protection. That environment typically follows periods when the market has already sold off sharply.
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 basing, 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, late in mid-May 2013, and again right at year end 2013, the public was mainly buying calls. In both cases they made exactly the wrong moves. Those very bullish moods occurred just as the market was poised to retreat.
Making money in the market requires fighting your emotions. It is normal to feel the same emotions as everyone else. It is not OK to trade like them.
