I recently had a chance to ask Steven Sears who writes The Striking Price column at Barron’s and is also the author of new book The Indomitable Investor: Why a Few Succeed in the Stock Market When Everyone Else Fails a handful of questions. He was kind enough to provide some really fleshed out answers to my questions, so I am going to run one each day this week. You can also read earlier posts here: part one and part two. Without any further ado here is part three:
AR: The VIX gets a lot of play in the investment world, but measures of skew do not. How can investors use skew to enhance their appreciation of market risk?
SS: If you like VIX, you will love SKEW. The funny word tells you if the options market expects a security to rally or decline.
Skew is based on the difference between the implied volatility of out-of-the-money puts and calls. Implied volatility expresses if a security is expected to move, up or down. By dividing implied volatility by 16 (square root of the number of days in a trading year), you can determine the daily movement priced by the options market. So a 16% implied volatility level means the options market expects a stock will move, up or down, by 1% each day until the associated security expires.
To determine direction – and this is skew’s value – most investors review bullish calls and bearish puts that are 10% above or below the market and that expire in three months. If put volatility is higher than call volatility, it is a sign investors are buying puts in anticipation of a decline and vice versa with calls. Sometimes, skew can be interpreted prima facie, and other times a contrarian bent is needed. The key is taking skew – which is not as widely followed as VIX and thus more valuable – and using it as a critical piece in your own overall analysis.
AR: You note that everyone in the markets has heard the dictum “Sell in May” but few take heed. Why is that?
SS: The results of that seasonal trade are stunning. A stock investment of $10,000 from November to April grew to $527,388 from 1950 to 2009. The same amount of money invested in stocks from May to October declined by $474.
So why does no one really respect the seasonal trade? Because no one wants to miss the chance to make money. Imagine if you are a portfolio manager and the market surges from May to October. How do you explain that to investors? Of course, the other issue is that selling is the hardest decision any investor ever makes, but that is another issue.