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Equity Skew Pricing and Strategies for Fast Market Declines

Article Quant Q&A · Author: Ray
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Summary

The discussion asks whether traders can profit from the tendency of equity markets to fall quickly and recover more gradually. It explains that this asymmetry is reflected in option prices: downside puts often carry a premium relative to comparable calls. A trader therefore needs a view on implied skew versus the skew that will actually be realized; the broad pattern alone does not establish an opportunity.

One proposed approach is to buy deep out-of-the-money puts to gain from a sharp decline. This position loses value through time decay while awaiting a large move, so it requires a long horizon and tolerance for ongoing losses. Selling skew is also mentioned as a potential source of returns because realized skew may be lower than implied, but crisis periods can create substantial funding demands and losses. Skew varies across assets: commodities and acquisition targets may show relatively greater demand for calls, while established large companies can have stronger demand for downside protection. These are general observations, not a reliable forecast for a particular market.

Key ideas

  • Equity option prices often reflect downside asymmetry through a premium for puts over calls.
  • A trader must compare expected realized skew with the skew already implied by option prices.
  • Buying deep out-of-the-money puts can benefit from a steep decline but incurs time decay.
  • Selling skew can face severe losses and capital pressure during market crises.
  • Skew patterns differ across asset types and company characteristics.

Tags

OptionsEquitiesVolatilityRisk management
Full text
# Given markets usually fall fast and rise slowly, are there trading mechanisms to take advantage of this?


# Given markets usually fall fast and rise slowly, are there trading mechanisms to take advantage of this?












Per a previous question on this topic -- markets generally fall fast and rise slowly: what options strategies or other strategies can one use to take advantage of this common occurrence?

## Answer by DKM (score 4)

https://quant.stackexchange.com/a/2460

To avoid confusion, this only applies to most equity/index option. In a return distribution, there's a measurement called skewness which measures the asymmetry of upside and downside. Let's define that as 30d Put Premium/ 30d Call Premium. It's already priced in because most of the time, skew > 1.

However, if you trade commodities or companies that might get bought, you'll often see skew < 1. You'd expect skew < 1 for a commodity because it's the safe heaven when the market tanks. For companies that might get bought (especially for a big premium), people are willing to pay for calls in case of a big upside gap move.

Typically mega cap companies have larger skew than a mid/small cap because it probably won't get taken out, doesn't have much upside because it's so established and so people are paying for the puts to protect against a black swam event like the BP spill.

So you can't really "take advantage" of that statement given there's implied skew already. It comes down to what you think about skew versus implied skew.

After all, realized skew is generally lower than implied skew so you'd expect to make money by shorting skew. However, in crisis times like 2008 and now, you need a lot of capital to stay short skew.

## Answer by Lliane (score 2)

https://quant.stackexchange.com/a/2447

Are you sure of what you advance ? Because I pay the same volatility for my 90% puts and my 90% calls.

## Answer by rajah9 (score 2)

https://quant.stackexchange.com/a/2449

Nassim Taleb has a strategy that he described in Active Trader magazine (partial interview here. As I recall, he would buy deep out-of-the-money puts, anticipating the faster fall.

He is called the actions of some traders, to sell deep OTM puts, to be "picking up pennies in front of steam rollers." In this case (buying those puts), he is the steam roller.

Of course, he is losing money every day due to time decay, so this strategy is for those with a long-term view.

Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.