We're hearing lots of talk recently about an arcane indicator called the skew index, which has been making noise with a sharp rise. Many have heard about the consequences of a high-skew level, but it's really a cause and effect situation. I've written about the topic several times over the past 10 years, let's review this tool so we do not become confused.
Skew bets are based on the "skewness" of options, or asymmetry vs. a normal distribution. Basically, if we look at a standard normal bell curve (you learned that from statistics class) there is a lean against one side or the other. When the data leans too hard the curve skews to that side (think of weight), and the apparent "skew" is one-sided the illusion is the probability is skewed toward the side with the heavier distribution.
What does this all mean and how does it relate to options trading? Simply put, when those trades or bets are lined up heavy, looking for the markets to get massacred, then we have good information about trader expectations and where the money is flowing. It is meaningful data to know a group of traders are making heavy bets against the market. These are low probability outcomes, but when there is a heavy lean to this bearish side it often pays off handsomely to take the other side of the trade.
Many "end of the world" bets have been made over the years, but none of those have ever been paid off. Recent skew levels for options have hit record high marks, but the expected "collapse" has yet to occur. Will they be right? Sometimes they are right and a nice profit windfall comes from a market drop into a correction or worse. But at 5% or less probability, I'll still play the other side of the trade.
