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A Look at the Skew



Prof. Succo -

Dr. John Hussman has an excellent column up on his site today addressing options pricing and the fact that implied volatilities are skewed. Apparently (as I am sure you already know!) out of the money puts have higher vols, while out of the money calls have lower vols. I'll let the good Dr. explain what he is saying, but my question is whether the buy-write funds you have discussed could be distorting this data compared to what used to be "normal", or whether they are simply compounding the issue?


Minyan James

MJ -

This good doctor is saying precisely what Minyans have been reading here in the 'Ville about options.

At the money options have been getting cheaper and cheaper over the last few years. They have now reached levels that indicate complacency.

But there is also this skew in options which delves deeper into market psychology and tells us what investors think of the distribution, or likely outcome, of where the market will go, as well as when it will get there.

The skew was absolutely flat before 1987 as investors sold out of the money puts as aggressively (or more so) than at the money puts (or calls). Since 1987 the market hasn't made that mistake, although the skew varies and we watch that.

Just recently the skew has become even more flat. I wrote about all this last week (and I have written about the skew extensively). I have said that a market correction would not be of the magnitude of a 1987 event because of skew. Now, that skew is flattening as investors become more aggressive in attempting to "generate income." They are taking more risk.

But the skew is still not as flat as 1987. So even as the skew flattens and we get more toward that direction, I doubt we will ever get to pre-1987 levels.

So we shouldn't wait for it.

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