Minyan Mailbag: Volatility Skew
The more ubiquitous or general the skew is, the more effective it is as a contrary indicator...
What is your take on volatility skew (not meant to be such an open-ended question)? Specifically, do you view volatility skew as a contrary indicator?
Say a stock has a large negative volatility skew (relative to its past volatility skews) …
Would you say that's a positive b/c so many of the nervous holders of that stock have already hedged their position (by buying puts), so there wouldn't be as much of a panic move to the downside?
Or, would you say that's a negative because the dealers/market makers (since they are more likely to hedge their position than most other market participants) are going to be shorter gamma (or less long gamma) as the stock moves lower, thus creating even more downward pressure as the stock moves lower?
I suspect that the direction of the implied volatility may also be important (i.e. if IV is climbing, then the above mentioned dynamic [dealers/market makers being shorter and shorter gamma as the stock moves lower] is more of a factor than if IV is dropping).
Does your opinion (whatever it may be) apply to an index ETF's too?
I'm not sure if I did a good job explaining what I meant, but you seem to do a good job of knowing what I'm trying to say.
By the way, I am going to start writing for www.globaltechstocks.com (Sanjay's site) next week.
Like life there are no hard rules (we can argue that one as well, but that is my take).
Skew (out of the money puts trading rich to out of the money calls) indicates that the market is concerned about the downside in that security. Does that concern mitigate the actual downside that occurs?
First, I think the degree of skew must be considered. If there is only slight skew it won't make much difference in the potential gamma that exists and it will not affect the supply/demand dynamics as much as the security declines. If the skew is heavy, as in General Motors (GM), unless the stock because of a news announcement or other unexpected fundamental development occurs, as the security drops to the strikes in question, the gamma will actually decline rapidly due to the expensive nature of the options. Another way of looking at it is that the put holders will realize how much premium they "own" and the risk therefore if they are wrong; they will be more inclined to sell those puts than if they were cheaper. The selling of the puts will slow the decline and may in fact cause the stock to rally for these technical reasons. Of course if GM declares bankruptcy it won't matter. It only matters in affecting marginal supply/demand dynamics.
Second, I think it matters if the skew is not ubiquitous. If skew is prevalent, as it was in 2002 and into 2003, in all stocks and indexes, it means there is general concern in the overall market that is not due to micro dynamics, but macro ones. Historically this is much more powerful in causing mean reverting dynamics than are micro fundamentals, like in GM. Investors risk preferences for markets are prone to be wrong much more mean reverting than those for individual stocks where inside information influences skew.
So, you are saying that if a stock has a large negative skew, as the stock moves lower, holders of puts will exit their positions thus causing the implied volatility on those puts to drop? Am I correct that you are not only looking at the current state of the volatility skew, but gauging what the volatility skew will look like going forward?
And the short answer to the question I had (is skew a contrary indicator) is if skew is ubiquitous (and large), then it is a good contrary indicator?
On the first part yes. Of course this does not guarantee anything. But on the margin, the more expensive an option, the more the holder has to lose, and the more "anxious" they will be in holding it. So we have to anticipate what the skew will look like when the stock gets to the strike. All very subjective.
On the second part yes as well. The more ubiquitous or general the skew is, the more effective it is as a contrary indicator because it is more due to sentiment rather than specific information in the market, part of which is being evaluated by insiders who know what is happening.
These are all generalization.
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