No End to the Bull

Misunderstanding Positioning -SKEW Index

In June last year I received a message from Callum Newman at Fat Tail Investment Research here in Australia. The SKEW Index was at an all time high and financial social media was full of predictions of impeding doom for global equities. Callum though, wasn’t swallowing the doom predictions without further investigation so he asked if he could interview me to provide an alternative perspective (he knows me too well so assumed I’d be a contrarian!!)

The misunderstanding around the SKEW Index is similar to what we see with other forms of option market analysis such as the Gamma positioning that I discussed in my previous newsletter.

What is Skew & the SKEW Index?

When we look at the options chains for any option contract we will see that not all options trade at the same Implied Volatility (IV) (even of the same contract and maturity). For an example let’s look at ES Options for March Expiry on Feb 22 2022

Data from Quickstrike/CME

We can see that the At-the Money (ATM) 4325 Strike options are trading at an IV of 25.54%. If we look at the Out-of-the-Money (OTM) downside (put) strikes they are trading at a higher IV. For example the 4275 strike is trading at 26.85%. This means that these downside put options are more expensive. We can also see that higher (call) strikes are trading at lower IV. This difference in IV among strikes of the same maturity is called Skew. This example is said to have a positive put skew and a negative call skew as OTM put strikes are trading at higher IV (than the ATM) and OTM call strikes are trading at lower IV.

There can be a number of reasons for the skew including demand/supply, market maker positioning and the fact that volatility tends to increase when equities fall and decrease when they rise hence the skew reflects how volatility might change.

Like IV, the skew is constantly changing with market conditions and expectations.

The SKEW Index is calculated from deep OTM put options to try to measure how much more traders are paying for these crash protection options relative to the OTM call options. A high SKEW Index (around 150) shows that deep OTM put options are trading at much higher IVs whereas a lower SKEW Index (say 110) means that those options are trading closer to OTM call options.

Back to June 2021

In June 2021 the SKEW Index reached a high of 170. This was by some distance its all time high; deep OTM put options were trading at much higher IV than both ATM options and OTM call options as traders/investors were buying put options in big size and market makes adjusted prices higher accordingly.

Chart and data from CBOE

(Fin)Twit doom merchants go viral

Now, if there are two things that retail trading social media loves they are, all time highs and indicators of doom. The SKEW Index at 170 was supposedly both.

So what we saw were a slew of predictions of impending market collapse which then filtered into mainstream financial markets reporting.

Spurce: Marketwatch

Source: ETF Stream

Source: Financial Times

The narrative was that this buying of deep OTM put options was a signal of an impending market crash.

My favourite reference was to predictions of a ‘Black Swan’ event. ‘Black Swan’ events are defined as events that were unforseen. So if many investors were buying crash protection options any future crash could hardly be described as a ‘Black Swan’!

What it really meant

As I told Callum in our interview (available to see here) the suggestion that the high SKEW Index was a predictor of a crash was an example of how retail traders and their gurus misunderstand market positioning and reflexivity. These traders believe that ‘the market is ahead’ hence their use of such indicators.

The assumption that the market is ahead is also a key foundation of technical analysis. However, as George Soros states in a number of his books and articles, the belief that the market is ahead suggests there is a pre-determined outcome. This is clearly nonsense.

The simplistic ‘market is ahead’ type analysis is probably the most commonly used form of analysis for retail traders and it is also IMO a key reason why so many retail traders struggle. Frankly the assumption is BS.

The high SKEW Index showed us that many investors had bought deep OTM put options to protect themeselves from a market sell-off. It tells us that market makers were pricing deep OTM options at much greater IV. This is in reality all it can tell us. It does not predict the future.

(NB: The high skew may create other opportunities but not the ones that retail trading gurus are looking for)

Taking our analysis further

It could be argued that this put option buying made a sell-off less likely as investors were well positioned; they were not as net long as they normally are so had a stronger/more neutral market positioning.

Owning put protection (hedge trades) means that if the market falls, these investors have some positive P+L which they could use to buy some of the cheaper stocks. Whereas if they had no protection they are often forced to sell during market weakness thus exacerbating the sell-off.

These are just a couple of the scenarios we need to consider but demonstrate the type of analysis that we should be making. Notice how we are looking two or three steps ahead.

Pricing In

As I explain in my book An End to the Bull, the opposing view to ‘markets are ahead’ is the idea that market ‘price in’ certain outcomes. This should lead us to investigate what they are pricing in, the potential liklihood of that scenario and also a consideration of what might happen both if particpants are right and if they are wrong. We must not assume that participants will be right. In fact, knowing the failure/underperformance of traders and investors why would we assume they are right in their predictions?

Choose Your Narrative

On Feb 22 I posted this on Twitter

This brings together the topic of the SKEW Index and the option Gamma positioning that I explained in my previous newsletter.

The Outcome

In the days after the SKEW Index hit 170 (28th June) US equity market volatility was actually very low and the Indices moved higher. There was a small 2 day sell-off in late July but nothing to justify either the high prices paid for the put options or the headlines. The record high SKEW Index did not predict a crash and those who traded based on those predictions lost money.

P.S. We see similar analysis of the VIX Index and the VIX is a topic I am sure I will be discussing in the future

The Conculsion

The quest for simple to use indicators appears never ending for retail traders and their gurus. Every piece of market data is being turned into an indicator, a predictor. For the most part this is not how the data should be used.

Analysing the skew can be useful for traders as we try to judge market positioning but we should not make simplistic judgements.

Those willing to go a bit further and delve deeper into the data and how it relates to positioning and possible outcomes stand a better chance of a more successful trading career.

Keep Well, Happy Trading and Keep Grinding

Gary

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