We emphasize changes in skew a lot in our reports and many of you may be wondering why? As option traders, we have long seen skew as a leading (or supplementary) indicator of price movement. What do we mean?
We know funds aren’t the end-all-be-all to the market, and oftentimes they are given way too much credit or blame for movement. But to ignore their position, and the way they change their position is a big mistake if your goal is capturing short term market swings.
Ok, disclaimer out of the way….so what does that have to do with skew?
When funds are net short futures, they often don’t do this without some sort of protection. In low volatility environments (all environments actually, but low works best), instead of placing stop orders, funds will often buy call options 1 to 1 or bigger vs their futures position. The relatively low cost of the option is easily made up if their futures position is right. And if they are wrong, the call acts as a stop on the futures order, and if it is ratioed vs the futures, it could even turn the trade profitable. If funds are long futures, they can do the same thing with puts.
Ok, so we didn’t really address skew change.
Let’s start with a situation where funds are flat futures. If they begin to sell futures (as they have been doing in corn recently), they will typically augment this trade by buying call options. Their outsize purchase of calls will raise the demand, and bid the price up relative to at the money options and you will see the price (and volatility) of the calls rise.
Over the past few years in the Ag complex, we have seen the options trade precede the futures trade. Big shifts in the skew (ex call buying) will usually happen 1 day before the funds step in and sell the futures and push the market lower.
Skew moves for other reasons as well, and sometimes just because the options must retain some value, but that’s a blog post for another time. For now, keep an eye on skew to gain some insight into how the big players are protecting their futures positions.