The SKEW index measures the impact of distribution asymmetry as a proxy for tail risk, while the VIX assesses the impact of total volatility risk
The SKEW index, akin to the VIX index, serves as a tool for investors to measure market volatility and investor sentiment. A crucial distinction between the VIX (Chicago Board Options Exchange’s CBOE volatility index) and the SKEW index lies in their measurements. The SKEW index measures the impact of distribution asymmetry as a proxy for tail risk, while the VIX assesses the impact of total volatility risk. Unlike the VIX, the SKEW index focuses on large market moves by examining longer out-of-the-money (OTM) options.
The SKEW value typically fluctuates between 100 and 150, with an average of 126 over the past decade. A higher SKEW value implies a higher perceived tail risk.
This concept leads us to the idea of establishing a SKEW rank comparable to the Implied Volatility (IV), which could serve as a potential trading signal. The SKEW rank is defined in the same way as the IV rank. Here is the formula:
So here comes the question – could this be a superior trading signal to the familiar IV rank?
To answer this, a study was conducted that evaluated 45 days-to-expiry (DTE) OTM positions of the SPDR S&P 500 ETF (SPY). Two scenarios were evaluated: 2 delta (2 standard deviations) and 2.5 delta (2.5 standard deviations) puts. Small deltas were chosen for this analysis because the SKEW index focuses on tail risks that have a very low probability of occurrence. Performance was compared when the IV rank was greater than 50 and the SKEW rank was greater than 50, with the leadership of 21 DTE.
The study showed that the 5 delta puts performed better with the IV rank than with the SKEW rank. By using the classic IV rank, traders can collect more credit and achieve a better average P/L with a significantly higher success rate.
With an even smaller delta of 2.5, puts attracted slightly more credit when entered with a high SKEW rank, but did not outperform those entered with a high IV rank.
The results suggest that the IV rank is a more reliable indicator of option premium sellers. It provides consistent performance and can be applied to any OTM option. Furthermore, the IV ranking is simple to use and readily available on almost all options trading platforms.
In conclusion, while the SKEW index is a unique tool for measuring tail risk using deep OTM options, it may not be the most effective indicator for premium sellers. Conversely, the IV rank, with its consistent performance and applicability to all deltas, proves to be a more valuable tool for options traders.
Kai Zeng, director of the research team and head of Chinese content at tastylive, has 20 years of experience in markets and derivatives trading. He is a co-host on several live shows, i.a From theory to practice and building blocks. @kai_zeng1
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