Options Traders Told Us the Skew Was the Key

10/17/2014 8:00 am EST

Focus: OPTIONS

Bob Lang

Founder and Chief Analyst, Explosive Options

According to Bob Lang, of ExplosiveOptions.net, when it comes to figuring out the next move in markets, option traders know a ‘dirty little secret’ that not many are prone to know or understand. It is a little thing called skew.

I don’t know whether it is relevant to label a market top. It’s fun to do and we can reference this or that name. We can guess and stab at levels all we want and while that is fun to endlessly call tops and bottoms, it can certainly cost you.  How many times can you get it wrong and will you run out of capital by the time you are right? I don’t know if Alibaba (BABA) is responsible for a market top…that seems rather silly to me.  But I do know market players were building up protection just before that moment and it can be seen graphically and with factual data.  The market will always tell you the truth.  And below you will see the options traders market nailed it—no cute/funny names attached—just the facts.

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When it comes to figuring out the next move in markets, option traders know a ‘dirty little secret’ that not many are prone to know or understand.  It is a little thing called skew, which is a real time view of where money is being bet.  (Simply put, ‘tail risk is the risk associated with an increase in the probability of outlier returns, two or more standard deviations below the mean.’) 

Be mindful that winning bets on skew require outlier moves, less than a 5% probability (like a black swan event).  I mentioned recently this ebola outbreak could be that black swan-type event.  There is no better way to decipher which way the market is leaning toward big moving events than looking at skew. The index hit just over 146 on September 19, the highest level of the SPX 500 (SPX) ever.  Why is skew important? See the chart below, and you’ll notice that each time we saw a circle, the market was pricing in a drop prior to it happening.

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The following was written on Bloomberg and reposted on CBOE.com on September 23:

In a recent column on Bloomberg.com, Callie Bost wrote:

“After three years of non-stop gains in the US stock market, investors are loading up on insurance at the first sign of trouble….Concern that the losses will worsen has increased demand for shorter-dated, out-of-the-money options designed to protect a portfolio’s value. The Chicago Board Options Exchange’s Skew Index, which tracks expectations for an outsized drop in US stocks known as tail risk, reached 146.08 September 19, the highest level since October 1998….The gauge has averaged 129.77 over the past 12 months, compared with a mean of 122.82 during the past five years…”

By Bob Lang of ExplosiveOptions.net

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