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Flat Skew


In a rising market we normally see over-writers become active. These are funds that hold stocks long term and sell out of the money calls to generate income. When they begin to over-write their positions, they believe the rally will slow and that their stocks will not rise too far over the strikes they are selling.

Their objective is not to get called out of their stocks (in most cases), for they want to maintain the long term cost basis of their stocks going forward. If the stock prices rise more than they thought, they can manage, and normally do, the position by buying back the current short option and selling an option with a higher strike and longer expiration. As long as stock prices do not increase too far and too fast, this is a reasonable strategy.

This process causes volatility to decrease as the market rises. Out of the money call prices become cheaper from the selling, which transfers "long gamma" into the hands of short term traders. As these short term traders trade this newly sourced gamma, this causes "actual" volatility to drop.

The resulting dropping of option prices in the out of the money calls causes skew: out of the money calls are cheaper on an implied volatility basis than at the money calls, which have a lower supply.

If the market continues to rise and if the call selling has been large enough, the process of buying back near term lower strike calls and re-selling higher strike longer term calls can cause the market to grind even higher. But the skew remains because there is continued selling of out of the money calls.

This time it seems the process is a little different. There surely has been the selling of calls. But as the market has continued to climb, the over-writers seem to have just bought back the calls they were short and not re-shorted higher strikes. This has left the skew very flat on the upside.

So the process seems to have stopped, at least for now. The flat skew tells me that the over-writing process at this point is very small. Over-writers seem to be expecting more of a rally and are waiting for higher stock prices to begin again.

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