Treasury Options Skews: Investment Signals or Noise?

This paper also addresses one additional question: is the degree of options skewness (also referred to as “risk reversal”) a useful indicator of whether U.S. Treasury prices are likely to rally or decline? For example, if OTM put options have become extremely expensive with respect to OTM call options, is that a sign that a Treasuries are likely to fall or is it a signal that they are oversold and likely to rebound? Likewise, if call options on Treasury futures become more expensive than normal vis-à-vis puts, is that typically a signal that Treasury prices are likely to rally or a warning sign that Treasuries are overbought and unusually susceptible to declines? As it turns out, more often than not over the past decade, it pays to listen to Treasury options traders.

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Do variations in skewness tell us anything about the future payoff of investing in U.S. Treasuries? Does extremely negative skewness send a buy or sell signal? What about extremely positive skewness?

To answer these questions, we indexed the skewness on a scale of 0-100 over rolling two-year periods and compared it to the return of the five-year, 10-year and long bonds versus the U.S. dollar (USD) in the subsequent three months (so there’s no look-ahead bias). For example, if the Treasury options 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 Treasury options market was the most positively skewed that 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 currency futures rolled 10 days prior to expiry from 2008 until early 2019.

Over this 11-year period, the results are striking: currency options traders often provided useful warnings of coming periods of outperformance and underperformance in Treasuries. When Treasuries were unusually skewed to the downside, bonds often underperformed. This relationship was especially strong at the long end of the curve (Figures 4-6). When Treasury options were unusually skewed to the upside, bonds often outperformed. The above results should be taken with a large grain of salt. Like any such analysis, it’s time sensitive and past average relationships should not be expected to hold in the future. Nevertheless, options skewness might be something that Treasury traders, even those who only use futures, physical bonds or interest rate swaps, might want to be cognizant of as they manage their portfolios, especially when skewness has gone to extreme levels, one way or the other.