Skew And Verticals: You’re Either With Me Or Against Me

After the many years I’ve taught option trading, skew is probably one of the least understood concepts. In theory, applying skew is really easy. You want to sell thigs that are more expensive and buy things that are less expensive. Most people get that, but the issue with skew is that it’s not the price, but the pricing.

The trading strategy that is the most impacted by skew are verticals and all vertical-based strategies. When you start to add up all the strategies affected, you start to realize how important skew really is.

As you study verticals, you’ll find that the pricing is impacted by two things, probability and skew. Handling probability is easy, just pick a strike that has the desired probability of expiring in-the-money (ITM). Understanding skew does become more difficult to grasp, but hopefully this primer will help work out the kinks for you.

History of Skew

In order to appreciate skew, it helps to start with a little history lesson.

Option traders are always pricing in the future movement of the stock or index they’re trading. Until 1987, the options market had always assuming that there was an equal chance of a large up-move or down-move (normal distribution). Black Monday changed that. The market suddenly realized that markets crash downward!

This was a painful realization for those that were long delta and particularly those that had sold put options. They were undercompensated for the risk of a market crash. Suddenly, the market was in a position where it had to price in the asymmetry of extreme movement for the major market indices.

Skew is Intuitive

The notion that stock market returns are skewed makes intuitive sense. Sure, there’s the saying that the “market climbs up the stairs and falls out the window,” but let’s take that a step further.

For example, if I told you that the S&P 500 was going to move 10% the next trading day, which direction would you bet it would go? It’s either a 10% move higher or a 10% move lower. To answer this, you would need to think about how many times the market moved higher by 10% in one day versus falling by that amount. Of course, you would have to conclude that markets crash downward and now upward.

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