Skew: A Great, Often Misapplied Metric
‘Skew’ is a somewhat misunderstood measurement that compares the relative prices of put and call options, each of which are 10% out of the money.
The Vietnam era’s Motown recording artist Edwin Starr might well have asked,
The raw numbers for skew are compiled by Credit Suisse and published each week in Barron’s options column, The Striking Price. Here is how options expert Steven Sears explains the indicator.
That last phrase (highlighted with the orange arrow) often confuses people, leading them to do the opposite of what is likely to be statistically better. Mr. Sears says high skew readings are ‘Bearish’.
High doses of put buying indicate negative sentiment among option traders. Unfortunately for them, that is typically best used as a contrary indicator. Option buyers are notoriously bad traders, especially at key market turning points. They tend to get very nervous only after stocks have gone down significantly.
Don’t just take my word on that. Decide for yourself after seeing the facts.
I’ve matched up the past year’s skew readings for the S&P 500 and the Nasdaq while pairing them with the respective charts of those indices. High skews almost always occur near short-term market bottoms.
Last week’s SPX skew was near the highest of the past 12-months. If history is any guide we’re more likely to see a nice upturn than a further down trend in the S & P 500. While there are occasional false signals the last four major lows each was accompanied by elevated skews.
Tech stocks don’t exactly parallel the more sedate SPY. That’s why Credit Suisse calculates a separate NDX skew. Last Friday’s Nasdaq skew reading was higher than those that were registered in mid-October 2013, during early February, mid-April and in the first week of August this year.
Each of those periods proved to be great trading opportunities for equity buyers, not sellers.
It’s not surprising that both the SPX and NDX skew readings were at 52-week lows right around year-end 2013, just as the DJIA and SPY closed at what were then all-time peaks. Traders were greedy when they should have been fearful. Now it appears to be just the opposite.
Don’t let jitters from the latest week’s volatility scare you out of stocks. Stop skewing yourselves by understanding how to profitably use this fine short–term (weeks to months) indicator.
