Equity Options Skews: Why No Surprises?

Equity index options are the least surprising of options markets. According to data and the best of our knowledge, out-the-money (OTM) call options have never cost more than OTM puts on equity index options – reflecting the greater concern of a market slump than a rally.  Equity aficionados won’t find this surprising. The biggest market moves like those in 1929, 1987 and 2008 were in one direction: down. Extreme gains in equities tend to follow major selloffs and don’t occur amid an extended bull market, which are usually orderly affairs. Value tends to build slowly but can wither instantly.

The degree of downside skewness in equity index options is hardly uniform. During corrections, downside skewness can become more extreme than average and after long bull runs can occasionally become evenly balanced (Figure 1).

Figure 1: Extreme Downside Risk is a Universal Feature of Equity Markets.

Given that skewness (also called “risk reversal”) isn’t consistent over time, one might wonder if it’s a useful investment signal as it appears to have been in Treasuries, certain currency pairs, energy and precious metals markets?  For example, is extremely negative skewness a sign of further downside to come or a sign that stocks are oversold and about to stage a rally?  Is less-than-average downside skewness a sign that equities are likely to rally further or a sign that they are overbought and more susceptible to a correction?

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To answer these questions, we indexed the skewness on a scale of 0-100 over rolling two-year periods and compared it to the actual payoff of a fully funded long futures position in the subsequent three months (so there’s no look-ahead bias).  For example, if the NASDAQ 100 option skewness was the most skewed to the downside it had been during the previous two years, the index would have a reading of zero.  If the NASDAQ 100 options skewness was the least negatively skewed than it had been during the past two years, the index would have a reading of 100. We then broke the results down into deciles and looked at the subsequent three-month performance of the reinvested futures rolled 10 days prior to expiry from 2008 until early 2019.

Unlike in Treasuries, where the market has tended to move in the direction suggested by the options skew, or in the energy and precious metals markets where options skewness has given strong contrarian signals, options skewness in equities hasn’t really sent much of a signal at all over the past decade (Figures 2 and 3). That said, there is limited evidence that the NASDAQ 100 has done best when options skewness was closest to its two-year moving average and less well towards the extremes.

Figure 2: NASDAQ 100 has Performed Best When Options Have Relatively Average Skewness.

Figure 3: S&P 500® has Performed Best with Average-to-Somewhat Below Average Skews.

These relatively weak signals should be taken with a large dose of salt.  These results are time dependent and relationship between options skewness and subsequent equity market returns could be very different in the future than it has been in the recent past. 

Still, one might one wonder why equity index options appear to give such inconsistent investment signals when those signals have been much stronger (though still subject to the same warning as above) for other asset classes.  The answer is that capital markets appear to adhere to their own version of Heisenberg’s uncertainty principle: the fact of observing something, changes it. Ever since the original VIX index was launched in 1986 (it changed to its current calculation methodology in 1993), equity index options have been widely discussed and studied by academics, investors and the financial media.  As such, both the level of volatility and the skewness of OTM options are probably being incorporated into market pricing quickly.  By contrast, academics, investors and financial media have traditionally paid much less attention to options on commodities, Treasuries and currencies.  As such, those markets may not be incorporating the information available in skewness as efficiently as in the equity market. That said, even given the apparent ambiguity in the relationship between equity index option skewness and subsequent investment returns, investment managers might want to pay attention to it as a barometer of investor sentiment and positioning.

Bottom Line

  • Equity index options have (unsurprisingly) always been skewed to the downside.
  • The degree of downside skewness varies over time.
  • Skewness has had an ambiguous relationship with future equity investment returns.
  • Equity index option skewness could still serve as a barometer of investor sentiment and positioning.

 

All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the author(s) and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience.

About the Author

Erik Norland is Executive Director and Senior Economist of CME Group. He is responsible for generating economic analysis on global financial markets by identifying emerging trends, evaluating economic factors and forecasting their impact on CME Group and the company’s business strategy, and upon those who trade in its various markets. He is also one of CME Group’s spokespeople on global economic, financial and geopolitical conditions.

View more reports from Erik Norland, Executive Director and Senior Economist of CME Group.

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