Skew in the stockmarket

[Cutten]

Is the skew in the stockmarket purely reflecting likely price distribution and/or the fact that stockmarket falls are usually accompanied by increasing volatility, or is there a component which is the result of institutional bias i.e. most fund managers and investors are net long, so like to get income by selling calls against their long stock, and get panic protection by buying OTM puts?

If the latter, what additional factors must be considered before you start selling OTM puts, buying OTM calls, and simply rehedging your delta each day?

 

[Maverick74]

Quote from Cutten:

Is the skew in the stockmarket purely reflecting likely price distribution and/or the fact that stockmarket falls are usually accompanied by increasing volatility, or is there a component which is the result of institutional bias i.e. most fund managers and investors are net long, so like to get income by selling calls against their long stock, and get panic protection by buying OTM puts?

If the latter, what additional factors must be considered before you start selling OTM puts, buying OTM calls, and simply rehedging your delta each day?

Skew is reflected by a lot of things. In 1987 the option trader community learned something very valuable that the Black Scholes formula did not make very clear. That is the prices can fall much faster then they rise. Ever since then puts have always tended to be priced slightly higher. If you think about it, it makes perfect sense. Stock very rarely, outside the bubble of 1999, explode to the upside. But stocks can fall very far very fast.

Also short term expectations by large specs will affect the skew and how steep or flat it is. Many traders actually use the skew as a contrarian indicator. They feel that large specs tend to be wrong a lot so if there is a steep call skew or put skew, they will take the other side.

Also, something that does not get talked about a lot is hard to borrow stocks. A lot of stocks have limited amount of shares available for shorting. These are called hard to borrow stocks. Because of this, the put premium will be priced higher.

And finally on farther out options you have interest rate skew. As rates go higher the prices of calls go up and the prices of puts go down. Not really much a factor in this low interest rate environment.

As for buying calls and selling puts and selling stock, you basically have a reversal on. The problem with doing this off the floor is no MM will let you do this trade for a credit, it would mean he is doing it for a debit which he won't do! So after paying the spread this strategy will not yield much a profit.