Equity Options Skews: Why No Surprises?

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?

• Agriculture Options Skews

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.

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.