Mat Cashman, Principal of Investor Education at the OCC joins IBKRs Senior Trading Education Specialist Jeff Praissman to discuss option skew and how it can be used to analyze markets.
For more free options education from The Options Industry Council (OIC), an industry resource provided by OCC, visit OptionsEducation.org.
Have an options-related question? Contact the OCC Investor Education team at [email protected] or via live chat on OptionsEducation.org.
Connect with OIC Instructor, Mat Cashman.
Note: Any performance figures mentioned in this podcast are as of the date of recording (April 10, 2023).
Summary – IBKR Podcasts Ep. 72
The following is a summary of a live audio recording and may contain errors in spelling or grammar. Although IBKR has edited for clarity no material changes have been made.
Hi everyone, welcome to IBKR Podcasts. I’m your host Jeff Praissman, Interactive Brokers, Senior Trading Education Specialist. It’s my pleasure to welcome back to the IBKR Podcast studio, Mat Cashman, Principal of Investor Education at the Option Clearing Corporation, or the OCC. Hey, Mat, how are you? Welcome back.
I am doing just fine. Thanks for having me again. It’s always a pleasure to be back on the podcast at IBKR.
It’s great to have you back in our studio, and today we’re going to discuss option skew, what it means, why it’s important and how it can affect positions and trading strategies. So Matt, let’s start from the beginning. What is option skew?
Option skew, that’s a really good question. Since we’re going to talk about option skew, let’s define it to begin with. Option skew is the difference in the at the money, the out of the money and the in the money options all priced within the same month. So, without having a whiteboard to draw it on, you should think about at the money options, in the money options, and out of the money options as all having their own individual implied volatility levels and the differences between those implied volatility levels is what creates the actual options skew.
Is it something that is innately priced into the options, or does it kind of come from supply and demand? Like where exactly does this skew come from? What is kind of the history of it? Like we have the history of options, our last podcast we talked about Ancient Greece. But you know, what is the history of the options skew and where traders kind of figured this out?
Let’s talk about first and foremost why it exists. So, ultimately what you said is really the answer to that question, which is it is a function of supply and demand. Option skew is all based on implied volatility levels and implied volatility levels are kind of linked inexorably to prices of options and so when the price of an option is going up, if you keep everything else relatively the same, the one thing that you can really surmise from the price of the option going up is that the implied volatility is probably going up as long as everything else is staying the same. So, the reason why option skew exists in its most basic form is the fact that supply and demand forces are out there with respect to the price of the options and thus, because the price of the options is inexorably connected to the implied volatility of the options … that affects the implied volatility levels, which is where the skew comes from. Now, we can talk about why it exists and like how it exists from a mechanic standpoint, but what we can really surmise from all of that is that the reason why option skew exists is because people are willing to basically pay more for some options relative to other options. When you think about the price history of the underlying think about what happens with equities and indexes. Generally speaking, price history has dictated that the moves to the downside have been more radical, more, they’re faster paced. They have more kind of acceleration. They’re scarier to some people and the movement to the downside because of that incorporates a slightly higher perceived implied volatility. And so, when you look at the way the skew looks from a graphical representation, you’re generally — when you’re talking about equities and indexes — going to see the options on the downside. Those out-of-the-money puts are going to have slightly higher implied volatility levels because supply and demand dictates that people, generally speaking, want to pay more for those options and thus their prices are higher and thus they’re implied volatilities are higher. So that’s really kind of — we unpacked a lot there, but that’s really where all of that comes from.
So, they’re really measured. Really, it sounds like measured in terms of volatility end price, and obviously, volatility leads to the price difference as well but is there an investor or trader looking at skew? It seems like they could look at a specific expiration and look at either the call skew, the put skew or both depending on what kind of picture they want to get of the options and depending I guess what their opinion or what they’re looking to do as far as take a directional position on or decide what a better investment for that particular month is.
Yeah, absolutely. And that speaks to the idea that you can measure it in a couple of different ways. This is by no means an exhaustive list of how people measure skew. Lots of people do it in lots of different ways but I’ll give you a couple of ways that people generally measure it and also talk a little bit about how kind of professional traders talk to each other about it because that’s also kind of instructive as to how the community at large actually uses these terms. Like the terminology to discuss how things line up. So, the 1st way that you can do it, and one of the most basic ways that people do it is that you can look at it just in terms of price. You can look at what that actual like — keep in mind we’re talking about the difference between two options that are that are priced in the same month. Generally speaking, not always, but generally speaking, people in the community, when they think about skew as a general kind of idea, they use most of the time the 25 delta put and the 25 delta call. Now, the reason why they use those is that they’re both equidistant from the at-the-money option, and generally speaking, when people think about what is the best indicator of how people are thinking about those options, those are the options that have … they’re meaty enough that they have the potential to actually come into play. They’re not like 2 delta puts and 2 delta calls, which are 10 standard deviations away. They’re actually options that have the potential to come into play and thus are within the actual pricing mechanism for the skew. People actually think about them as what we would consider real options, right? They’re options that have an ability to come into play during the during the tenure of that month and so people will sometimes look at just the price of those two options. Look at the price of the 25 delta put, look at the price of the 25 delta call and then subtract 1 of them from the other. So, in the case of an equity or index in the United States that 25 delta put is going to generally, because of the forces of skew, be more expensive than that 25 delta call. Now that’s not always the case. It’s not like built into the way the options are priced necessarily, but most of the time, that’s how it works. And so, you can take that 25 delta put, you can subtract the price from the 25 delta call and you can get the difference between those two and you can track that over time.
Now the way that options traders, market makers generally refer to that, they’ll call that the combo in some markets. They’ll also sometimes call that the risk reversal and so what those people do is they tend to look at that as a price and track that over time. Sometimes people use that as a metric to be able to understand where people are placing more of the supply or more of the demand. Where are people willing to buy more options or sell more options? In the case of a risk reversal that is extremely pronounced from a value perspective, let’s say the risk reversal generally trades $0.50 to the put. If that risk reversal all of a sudden is trading a dollar and a half, people are going to look at it and say what is going on here? Part of the reason why? Maybe. Again, those forces of supply and demand pushing the skew up, we would talk about in the market-making terms. We would say the skew is really high on those puts or the put skew is very high. There’s another way that people sometimes look at skew, and you can look at it not only in price terms of the 25 delta put versus the 25 delta call. You can look at the volatilities of those two options and have 1 divided by the other. That will give you the ratio of those two options’ implied volatility. Some people look at that. That will give you the same kind of metric overtime as just the price would. Again, price and implied volatility like I said before, they’re inextricably linked between the two.
The other thing that some people do is they’ll look at 25 delta put as a function of the at-the-money put, the 50 delta put and they’ll also look at the 25 delta call as a function of the 50 delta call. What that does is it gives you an idea of how the put skew independently is priced or the call skew independently is priced. The reason why is because it takes the fact that you’re actually comparing the put and the call to each other out of that and it actually compares puts to puts and calls to calls. The 50 delta call to the 25 delta call. That will give you an idea of how high or low the call skew is independently and that 50 delta put versus the 25 delta put can give you an idea of how high or low the put skew is independently. So that’s just a couple of ways that people keep track of it and a couple of ways that people generally like to kind of talk about it amongst themselves as traders.
Matt, you just brought up a ton of good points and I want to take a deeper dive into how traders can use skew to analyze markets a little bit later in the podcast. But I actually want to take a little bit of a step back just for our listeners that maybe aren’t very familiar with skew and talk about what is considered a typical skew. And in my mind, I’m thinking there’s really couple different products such as equities and indices on one side and then also like options on commodity futures. And my question to you is, is it a one-size-fits-all skew for everything, or are there differences in what’s the quote-unquote, typical skew for different products?
That’s a really good question and it speaks to a couple of different ideas. Now the first idea there is that … the answer to that as far as whether it’s a one-size-fits-all situation is absolutely not. There’s not one prototypical skew that exists for all of those products that you just mentioned. Each product generally has its own kind of history of skew and it’s kind of individually based around the product itself and part of that is because of idiosyncrasies of how the price of the underlying performs overtime. If you think about equities and indexes and I mentioned this earlier in the podcast that equities and indexes tend to crash to the downside and stair step price wise up to the upside. So, the moves to the downside, although they’re not always like this, when they happen in large like a three standard deviation move to the downside. Generally speaking, as far as price is concerned, for equities and indexes, that’s where those crashes happen. That’s where people get really scared. The other thing that you have to keep in mind is that generally speaking, people from the average 401K in the United States or globally for that matter, is going to be long the actual underlying. They are going to be long equities, long indexes and so what happens is that there’s more fear to the downside that happens then there is optimism to the upside. People expect stocks to go up. They don’t expect them to crash, and so when the crashes happen, that’s when people start to really kind of freak out. And what that means is that those downside strikes are going to theoretically have higher volatilities because of the price history that is embedded in the underlying. The other thing that’s embedded in there is that there’s a little bit of option flow that exists in the equity and index world that the average person that’s long the underlying is going to naturally be a buyer of puts and a seller of calls for lots of different reasons. Protection to the downside, and in some ways, people like to sell calls against their underlying positions to generate income to the upside.
And so, there’s also an embedded order flow that exists in that equity and index world that pushes the skew in that same direction, meaning that the puts are higher than the calls. Now contrast that with commodities, think about commodities and how those commodity prices move. Generally, if you’re going to talk about let’s talk about, for instance, agricultural options, grains. I traded corn, soybeans, soy oil, soy meal, wheat … all of those things generally have what we call demand skew or call skew, meaning the calls, the out-of-the-money calls, are higher in implied volatility terms, then the out-of- the-money puts. And the reason why is the exact same reason that you have as far as the equities and indexes are concerned to the downside. Those actual prices for the underlying actually explode to the downside and stair-step to the upside. Well, commodities are the exact opposite. You have to flip it around in your mind. Commodities actually explode to the upside and stair-step down to the downside. The reason being is that they have what’s called demand skew. When the sun shines in Illinois in August and it’s 100 degrees for seven days straight, the soybeans get killed. And if the soybeans get killed, there’s not as many soybeans to go around the crop will be smaller. The demand is still there. People are going to continue to eat edamame and what happens to the price is that it explodes to the upside. The reason being people need to actually have that underlying soybean future or they want to take delivery of it and they’re willing to pay X amount for it and so the explosion in price happens to the upside. You’ll see that play out in how the options are priced in that regard. The calls themselves will have higher implied volatility than that puts in the out-of-the-money options because of that same price iteration that continues to happen. And the underlying, over the history of those products the explosions have happened to the upside, not to the downside, and so the options to the upside are just naturally going to be more expensive from an implied volatility perspective.
And that makes total sense too, because you can take an airline company that may need to hedge out their fuel for a certain number of times and they’re going to protect themselves on the upside versus the stock investor who, like you said, is protecting maybe his downside in case his position crashes a little bit. So that absolutely makes sense. There’s two really different quote-unquote typical skews.
And that’s why those commodities have that price, that price history that exists in that way because if you think about it, actual airline needs to have the actual underlying airline fuel to run their business, right. It’s an actual input into their business model, and if they don’t have it, they can’t make money. And so, they’re willing to pay an awful lot for that when it becomes scarce as a resource.
Traders can use skew, not just in the here and now, but I would assume that they’re going to measure over a certain time period. Sort of help form their investment decisions as well. What is a typical time period that traders will look back on? Is it six months a year, five years or really is it just depend on what they’re trying to do and in different circumstances as far as taking into account the investment they’re trying to make or the trade they’re trying to make?
Yeah, I think that’s a really interesting part of this. And the reason why is because there’s lots of different ways that you can measure it, right? You can measure it in time over how long the options lifetime is. So, a lot of people will keep track of the 30-day option skew or the 30-day call skew meaning they’ll look at that constant maturity 30-day option and look at the difference between those two valves for the 25 delta call and the 25 delta put and constantly measure that as just the metric that they keep track of or they’ll look at just the call queue for that same 30 day option constantly. But the other part of that is that people tend to look at the historical skew of what things might look like for that product specifically. For instance, what does the SPX skew look like historically for that same maybe 30-day option over the last 10 years or over the last year, or over the last 30 days? And that is also kind of infinitely customizable as far as what period of time you want to look at.
Generally speaking, if I were to speak from my experience specifically as a trainer, it becomes hard when you start to look at really giant pieces or giant sets of data as far as especially things like skew because it can be so esoteric as far as in some instances, right? Certain regimes of markets will tend to produce skews that look different from other skews. And so, if you look at something over a course of a very long period of time, like 10 years or 20 years, what you’re going to end up with is something that’s very noisy and has a lot of different, like I said, regimes, as far as like the Fed was raising during this point in time. The Fed was on hold during this time. The Fed was very accommodative during this time and each one of those regimes is going to kind of produce its own set of skews more generally. And so, I think that it’s important for people to look at it in terms of — make sure when you’re looking at data like that, that you’re looking at it intentionally, not just as like, let’s look at the last 10 years and see what you should be. In some cases, you’re going to find that the more data you get, the more convoluted the actual idea becomes as to whether or not skew is priced correctly from a historical perspective, because of the fact that, like I said, there’s all kinds of different things that can happen over the course of 10 years. Whereas if you look at it, what has skew looked like over the last 30 days? You’re going to have a much better idea of what things might be for the present day, for the options that you’re looking at that are directly in front of you as opposed to 10-year options that you’re going to need to price for skew. That’s a much harder idea to kind of parse out as far as that data is concerned.
That makes total sense. There seems like there’s really three or four main factors that can affect the skew price such as order flow, bearish or bullish sediment, price movement. If you’re taking that 10-year period, there can be so many factors involved versus like you say, let’s just look at the last 30 days and it’s probably less variables and you can kind of really see where this skew is going or where it’s been and kind of compare itself to itself, it’s historical average.
There’s also one other point there that I think is important, which is if you’re in a certain circumstance where you think that there has been some sort of regime change, as it were. Whether it be for more broadly, like the big broad market index, like some sort of huge macro change like a Fed change, or whether you think that there’s some sort of change that’s happened specifically for a single name stock that you’re treating that is theoretically regime changed. Like for instance, in a certain circumstance where people were really worried about the downside for a stock. And then all of a sudden, something came out that they announced that took away some of that downside worry. You should really consider that in your framework of the idea of what these options should be worth, because in some way, shape, or form, those regime changes or those kinds of like … I used to turn them as Vol reducing events are going to change how people perceive those options to be worth, and thus it’s going to change the price of those options. And then again, like we said, prices of options and implied volatility of those options are linked and thus it’s going to change the skew or the way the skew looks for those options and it can be very pronounced in one month versus all the other months that exist that are priced for those options. So, make sure you pay attention to that as well.
Our listeners want to know how you can be used to analyze markets. And as we discussed, traders can look at sort of its historical average and see how it compares to it currently. What are some other ways that you know traders can use skew to analyze markets?
First thing that comes to mind is that a lot of people use skew as just a sentiment indicator. People like to look at it and say — like I said before in that previous example — people are really worried about the downside because the skew is priced very aggressively to the puts. Meaning, those puts are relative to historical averages. Let’s say these puts, these 25 delta puts are very high relative to a five-year historical average, or a two-year historical average. They’re trading at 1.5 times what they would normally trade at from an implied volatility perspective. And the calls, conversely, are extremely depressed relative to where they would normally trade. Some people will look at that and see that as just ok well, supply and demand forces are at work here and people really want to buy the out-of-the-money parts and they don’t really care very much about the out-of-the-money calls. And so, the sentiment has shifted to the fact that people are worried about the downside of that. Now the other way that people can from a trading perspective … it’s not always perfectly aligned with the fact that high put skew from a historical basis and low call skew doesn’t always mean that people are really worried about the downside. That’s the funny part about this, is that sometimes because of the fact that it’s really connected to supply and demand that really high put skew can just mean that there’s someone who’s bought a lot of puts over the last six weeks or something. We would call it from the market-making perspective, we call that perma-bid, right. The puts are perma-bid, meaning they never go down. I don’t understand why they never go down. I’m short so many of them can’t even handle it over as far as my overnight risk is concerned, and there’s no theoretical like macro reason why they should be this high relative to historical averages. But so many times those things would happen, and it was just quite honestly a function of supply and demand. It was just the fact that someone continued to buy puts no matter what. The bell would ring and the puts would start trading and the first thing that would happen in the morning is someone would come by 5000 puts like every single morning. Well, if that happens supply and demand is just going to push those puts up, right? They’re going to be high. They’re going to be high in implied Vol terms. They’re going to be high in price terms and that doesn’t always necessitate the fact that everyone’s worried about the downside. It may just be one person who’s buying a lot of puts, so it’s really important that you think about it in those terms as well. But a lot of people do like to use it more broadly as a sentiment indicator, especially when you look at it in terms of how the puts are priced relative to the calls in things like the indexes, the broad-based indexes. You’ll hear people always talking about the VIX as they call it the fear gauge right? As people call it. Really, the VIX is just a measure of the 30 day at-the-money implied volatility level of the S&P 500 options. There are other ways that people measure the actual skew of the options. I actually think that there’s a Cboe Index, now called the skew index that actually measures that, and people will look at that as a sentiment indicator for the broader markets.
Do they also look at like say, different peer groups? So in other words, I’m looking at Coke and Pepsi. Does that ever come into play where they might say, ok, Coke skew is more to the downside than Pepsi. I think Pepsi’s increase in price or whatever … or is that not really a good use of skew and it’s more sort of more isolated for its own individual self.
Well, I mean there’s varying degrees of whether or not that’s useful. I would say if you’re doing things like trading something like relative value trades where you’re going to be trading Coke puts versus Pepsi puts or something along those lines, you’re going to be trading stock XYZ puts versus stock ZYX puts. That can be useful, but I also think that it’s important for people to look at it in terms of what we just talked about as far as order flow is concerned. Sometimes there’s just order flow that exists in one product that doesn’t exist in another product. And if you can get in there and kind of comb through the data, there’s a lot of different ways to look at how that data lines up and how it can kind of tell the story of what’s really going on from the options trading flow is concerned. If you can get in there and parse through that data and be able to tell the tale of how those puts are trading versus how those calls are trading in terms of like there’s just a large buyer of these options and none of these options. It can help to explain away some of those differences in skew as far as that’s concerned, but having one skew versus another skew is definitely a trade that is out there, and people do do that.
We used to trade that on a relative value basis. Now, we did it in the interest rate options quite a bit where I used to trade a long time ago and we would trade interest rate options on these bonds versus interest rate options on these bonds and we would trade 25 delta puts here versus the 25 delta puts here. We would say this skew is high relative to its historical averages. So those trades do exist. I think it’s important that you build in an idea of order flow and an idea of just general supply and demand when you’re evaluating those trades to be able to kind of build a mental framework around why one skew might be higher than another skew within that peer group of those stocks that you’re talking about as far those two that you referenced earlier.
Matt, this has been a great conversation about skew. And again, I think it brought a lot of value to IBKR Podcasts. It’s something that I think a lot of people don’t discuss enough, so I want to thank you for coming by. I also want to remind our listeners that for more information from Matt and the OCC, please go to our website under education to view previous OCC webinars as well as our previous podcast, Episode 61: From Ancient Greece to Daily Expirations: the Evolution of Option Structure and Trading Volume as well as keeping up an eye out for any upcoming live events. I also want to remind everyone that you can find our podcast on our website under Education, scroll down to IBKR Podcasts, or they’re available on Spotify, Apple Music, Amazon Music, PodBean, Google Podcasts, and Audible. Thank you for listening, until next time, I’m Jeff Praissman with Interactive Brokers.
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