Open Interest and Skew: A Deeper Look into Market Expectations
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Volatility skew, the phenomenon where options with the same expiration date but different strike prices have different implied volatilities, is a rich source of information about market expectations. When combined with an analysis of open interest, it can provide a effective, three-dimensional view of market sentiment and positioning. This article will explore the intricate relationship between open interest and skew, and how professional traders can use this combined analysis to gain a deeper understanding of market expectations.
The Skew: A Window into Fear and Greed
In a theoretical, risk-neutral world, all options with the same expiration date would have the same implied volatility, regardless of their strike price. In reality, however, this is rarely the case. The volatility skew, or "smile," is a reflection of the market's perception of risk. In the equity markets, the skew is typically downward-sloping, meaning that out-of-the-money puts have a higher implied volatility than out-of-the-money calls. This is because investors are generally more fearful of a market crash than they are greedy for a market rally, and are therefore willing to pay a higher premium for downside protection.
Open Interest: The Weighting Factor for Skew
While the skew provides a qualitative measure of market sentiment, open interest provides a quantitative measure of the conviction behind that sentiment. A steep skew in the puts, for example, suggests a bearish sentiment. But if the open interest in those puts is low, it indicates that the bearish sentiment is not widely shared. Conversely, a steep skew accompanied by high open interest is a much more effective signal, as it suggests that a large number of market participants are positioned for a downside move.
A Formula for Quantifying Skew-Weighted Open Interest
To quantify the combined impact of skew and open interest, we can create a "Skew-Weighted Open Interest Index" (SOII):
SOII = Σ [(IV_strike - IV_atm) * OI_strike]
SOII = Σ [(IV_strike - IV_atm) * OI_strike]
Where:
IV_strikeis the implied volatility of the option at a specific strike priceIV_atmis the implied volatility of the at-the-money optionOI_strikeis the open interest at that strike
A high positive SOII for the puts suggests a strong bearish sentiment, while a high positive SOII for the calls suggests a strong bullish sentiment.
Skew and Open Interest Table
Let's examine a hypothetical skew and open interest table for the stock XYZ:
| Strike Price | Call IV | Put IV | Call OI | Put OI | Call SOII | Put SOII |
|---|---|---|---|---|---|---|
| $90 | 35% | 45% | 500 | 10,000 | 2,500 | 150,000 |
| $95 | 32% | 42% | 1,000 | 8,000 | 2,000 | 96,000 |
| $100 | 30% | 30% | 5,000 | 5,000 | 0 | 0 |
| $105 | 28% | 28% | 8,000 | 2,000 | -16,000 | -4,000 |
| $110 | 26% | 26% | 12,000 | 1,000 | -48,000 | -4,000 |
In this table, we can see that the puts have a significantly higher SOII than the calls, suggesting a strong bearish sentiment. The high open interest in the out-of-the-money puts is amplifying the effect of the steep put skew.
Actionable Example: The Skew-Enhanced Risk Reversal
A risk reversal is a strategy that involves selling an out-of-the-money put and buying an out-of-the-money call, or vice versa. The goal is to profit from a directional move in the underlying asset. The selection of the strikes for a risk reversal can be greatly enhanced by an analysis of skew and open interest.
A professional trader might look to sell a put at a strike with a high implied volatility and a high open interest, and buy a call at a strike with a low implied volatility and a low open interest. This would create a bullish risk reversal with a favorable risk-reward profile. The high premium received from selling the expensive put would help to finance the purchase of the cheap call, and the high open interest in the put would provide a cushion of support for the stock.
By combining the analysis of open interest and skew, professional traders can gain a more nuanced and complete picture of market expectations. This allows for the development of more sophisticated and profitable trading strategies that are tailored to the specific risk-reward profile of the market.