Volatility Skews

By the third week in November, US volatility futures were trading in backwardation. That is longer term volatility futures expiring in January and February were trading at lower values than the cash market.

For traders who look to volatility as a way to gauge investor sentiment, that volatility skew can enhance one’s perception of risk and augment its usefulness as a forecasting tool.

Most futures contracts are priced on a cost of carry model where longer dated futures contracts trade at a price that simply adds to the cash market a cost of carrying the underlying commodity until a future delivery date. Although with interest rates near zero, the cost of carrying commodities in particular is no longer as significant a factor causing sentiment to play a more dominant role in the pricing metrics.

Volatility, on the other hand, is priced solely on the basis of investors’ expectation about risk. Since volatility is not a commodity to be delivered at some point in the future it has no intrinsic cost of carry. Volatility futures can and often do, trade at a significant premium or discount to the cash market.

This is particularly true when there are time sensitive macro issues at play! In this case the fiscal cliff which has a specific timeline in January 2013. The fact that volatility is lower in the January contracts suggests that traders are beginning to feel that a deal to avoid the cliff may actually occur. To that end, there are some analysts and financial commentators who have gone so far as to suggest that back room negotiations already have the broad strokes of a deal in place.

The volatility skew seems to support that position which adds credibility to the possibilities. Even more so when you consider that we are at a very different place than was the case during the first two weeks of November. At that time longer dated volatility numbers were significantly higher than the cash month – i.e. a positive skew- implying that a deal was anything but a sure thing.

Of course volatility is not forecasting specific political outcomes but rather it is forecasting market reaction based on an outcome. When the volatility skew is positive – i.e. higher volatility in longer dated futures – it is anticipating an increase in market volatility and that is typically bearish for the market over the short term.

For option traders, the volatility skew can be a useful short-term forecasting tool. Not so much in terms of the steepness of the skew but rather in the shifting of the skew.

For example, when the skew shifts from positive to negative that is seen as a positive for the stock market. At the time of writing as the volatility skew shifted from positive to negative US stocks rallied prior to the US Thanksgiving.

Conversely, traders would view a shift from a negative to a positive skew as bearish for the stock market. Especially over the short term, say one to five trading days.

That said traders need to be aware that any sentiment indicator is skittish at best. And that skittishness gets amplified when dealing with volatility skews. That’s because volatility is itself quite volatile. The skew can shift quickly and in some cases has a tendency to move sharply from negative to positive and back again without warning. In much the same way as a stock will react to a shift in sentiment or an earnings surprise.

I suspect this will be of particular concern over the coming weeks as the fiscal cliff approaches. There will likely be an abundance of sentiment shifts as traders weigh the political rhetoric and the attendant potential of a positive outcome.

The bottom line for those among you who engage in day trading strategies, paying attention to the skew can be helpful… and dangerous at the same time.