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Expensive Skew

Despite a rather large decline in at-the-money implied volatility, skew still remains relatively high on the S&P 500.  The spread between 90% three month implied volatility and 110% three month implied volatility is at 10.5%, which is well over the 3 year average of 9.39%:

High skew makes buying “crash protection” very expensive.  My suggestion would be to purchase put spreads for downside protection, or purchasing your crash protection on Asian or emerging markets that look much cheaper.  I personally like to take advantage of steep skew by buying put ratio spreads.  A put ratio spread is when you sell more out of the money puts than the near or at-the-money puts that you purchase.  The positions often result in a net credit, so it provides cheap protection for smaller market corrections.  On the downside, if the market truly crashes, you find yourself with a losing position.  This could be mitigated by buying the put ratio spreads in markets with expensive skew (S&P 500) and purchasing out of the money puts in markets where skew is cheap.

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  1. Joshua says

    I’m glad you wrote this. I never thought of using two different markets for a ratio spread. Very creative. This should definately help ratio spread traders, who only trade options in the S&P.

Continuing the Discussion

  1. FT Alphaville » Bernanke’s genie released linked to this post on November 5, 2010

    […] Now here’s the interesting thing. Before Ben Bernanke’s Jackson Hole speech the skew towards downside protection in the S&P 500 had reached very high levels and downside protection was looking expensive. […]



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