On the wings of skew

Using FALC as an indicator and investment strategy

Setting the Table:

• Markets, once again, prove they can go in both directions. Hardly a volatility event, but we’ve seen ATM Vol in SPX go from just under 10 to just under 12 in the last 4 sessions.

  

  • While the curve is up just under two points overall, there’s a bit more perkiness to the downside. 

• This gap is best demonstrated with the FALC indicator, which measures the difference between 15 delta calls and 15 delta puts.

  

  • As the market has fallen off the past few days we see the puts catching more of a bid than the calls. 

• In the QQQ I’ve included a smoothed 10 day moving average to better see the long term trend. Both FALC30 and FALC90 have been ticking up for almost two weeks.

  

• There are many reasons skew gets bid up. During market panics, we often see investors clamoring for puts faster than calls. Skew can also rise during falling volatility periods, where the puts are “stickier” than the calls. While both drop, ATM and calls move faster than puts. 

  • Finally, we also see a dynamic in individual equities or commodity stocks where the calls are bid over the puts. This expectation is that rising prices lead to higher volatility, and if that sounds like Bitcoin or GME, you’re right. 

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Identify:

• After absolute volatility level, skew is one of the most important variables to pay attention to in the options markets. Implied volatility is a single percentage indicator that gives you an annualized move expectation for that option. All along the curve there are different prices for volatility, because there is a relationship spot level and volatility. Skew describes what vol to expect in the wings. 

  • If SPY is trading at $522.61 today, the 30 day ATM vol is roughly 12%. At 15 delta (~$500) we have an implied vol of almost 16%. Both are true, because what the 500 strike calls/puts are saying, is that conditional to stock going down to $500, we should expect to realize closer to 16% annualized. 

  • The skew value measures kurtosis, or the tails of the distribution. Once a 12% vol stock goes down 5%, we expect its volatility to increase quite a bit. It has already realized a certain move, but further, volatility clusters and has its own momentum. The returns thus show skewness, and we have to account for that in the expected value price. 

• We can use skew both as an indicator, and a tradeable value. As an indicator, we’ll investigate its relationship to VRP and overall market liquidity. We can also trade the skew level in a product, either alone or as a complement to equity positions. Selling skew (you collect premium short put /long call, and you’re axed for that spread going lower) can be a stock replacement with extra premium. 

  • The caveat to trading skew is that you’re not just short a static value, you’re also short the extremes. Being short naked skew is a high risk endeavor - which is where the extra premiums come from.

  • A great piece of literature on this is from Euan Sinclair and Blair Hull “The Risk Reversal Premium.”  

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Read about Harvested Financial’s implementation here. 

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