Don't Get Skewed


I want to discuss the difference in volatility between out of the money (OTM) calls and out of the money puts. That difference is called the skew. Take an imaginary stock or index that's trading at 100. The 120 call and the 80 put are each equally out of the money. Both have a theoretically even chance of getting in the money. Logic would suggest that they trade at least at the same price. In fact, theoretically speaking the call should trade at a greater value because the stock can go infinitely higher while it can't go below zero. And, yet in almost every case the put trades higher. Often dramatically so. There are two reasons for that:

Firstly, think of an OTM call as a manifestation of Greed and an OTM put as a manifestation of Fear. Fear is a stronger emotion than greed (sure as heck is with me). Secondly, there is a natural supply imbalance in calls as people sell them against their stocks. And there is a natural demand imbalance in puts as people buy them for protection. Once again, we call this difference the skew and it changes and these changes can be taken advantage of by a savvy trader. The skew is at the very least a good indicator of market sentiment.

Let's take a real life example. At this writing (9:00 CDT) the SPY (S&P 500 exchange traded fund, or ETF) is trading at 185. The March 190 call and the 180 put are each 5 points out of the money. Yet, the put is trading at 1.40 and the call is trading at just .45. The put is nearly 3x more expensive! Granted, the market is falling (no surprise there) so one could expect bearish sentiment, but still this is a good illustration of skew.

The only time you will see a positive call skew in a stock is if the stock is a take over candidate. And a flat skew, ie the call and put are trading at the same price, is often a sign of complacency. Meaning investors are under protected against a down move and is a warning signal.

So, pay attention or you might get skewed!!

By: Randall Liss, The Report Liss