Oct

31

 In the lengthy thread regarding "whether markets decline faster than they rise," I did not see any mention of the put/call skew in S&P. It's well documented that, at least since 1987, during most "normal" periods, out-of-the-money puts are rather more expensive than out-of-the-money calls. There are several ways to explain this phenomenon:

1) Markets fall faster than they rise — and options traders know this. Otherwise, arbitraging this difference would be a meal for a lifetime.

2) Market participants perhaps anticipate that the realized volatility during a bear market is greater than a bull market. However, the problem with this analysis is one might expect to see an upward sloping volatility yield curve in out-of-the-money puts (during bull markets), and yet that does not usually occur based on my tests. Conversely, right now have a downward sloping yield curve in out of the money calls — which confirms the hypothesis that market participants anticipate slower price rises in the future. [Note to quants: I am not confusing delta, gamma and vega. I'm using options to predict terminal price at expiration.]

3) For most humans, fear of loss is a stronger emotion/motivator than the pleasure of gain (greed). This is well documented in the psychology and behavioral finance literature. Hence, ceterus paribus, capital market participants (who have a net long position) will, as a group, pull their rip cord faster — to flee from risk — than they will embrace the possibility of profit.

4) Lastly, my tests show that, in certain commodities, the exact opposite behavior to S&P occurs. For example, and perhaps due to the inelasticity of demand for grains, more-often-than-not one sees a call/put skew on the call side. Every so often, after a quiet "normal" period, one does indeed find an upward acceleration in price change correctly predicted by the put/call skew. Once suppy/demand is normalized, the (inevitable) ensuing bear market is much slower. These are generalizations of course, but I've found them to be true over the years. Bottom line: Market participants anticipate that stocks do indeed decline faster than they rise. The options market is priced for this outcome. And if it were not true, you could arbitrage the put/call skew.


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