HOT SHOTS: Appreciating a Negatively Skewed Reality?

When dealing with spreads, most options traders have to face the somewhat notorious negative skew that exists. It would be nice, of course, if the world was a perfect place and market makers would just make the trade line up nice and simple by offering out “the tough leg” at a fair price. Unfortunately, that’s generally not the rule because reality can, at times, become very harsh and beyond the scope of normal volatility—just like what’s been happening lately. And those guys on the other side, well, not so shockingly, are privy to that same awareness. Further, being a rather smart lot as to order flow and general market dynamics, to a certain extent, if you want to play, you have pay.

It’s for that reason that most often we will find those pesky little puts, for instance, taunting us by never going down in value and forcing us to “pay up” should we opt to seek a good night’s sleep with a limited risk position. With that said, though, is it really that bad? Considering the alternative and when executed as part of a well-intentioned trade, the answer is an emphatic “no” from this corner. In the following and for educational purposes only, I’d like to illustrate this point with Lexmark () by going through some steps / analysis that confirm an instance where negative skew might be considered an idea to embrace.

Going through a canned scan on Platinum for high implied volatility on a twelve month basis, Lexmark caught my eye Wednesday evening. The stock had been monitored since late June when I read some analysis at seekingalpha.com. The article made a decent-sounding argument, at the time, for Lexmark’s valuation, which could make it an attractive target for the now defunct “PE.” Somewhat unfortunately, the piece worked as an anchor of sorts and pushed my bias towards finding a bottom for LXK, right smack dab before another price jaunt lower.

More fortunately, while close to pulling the trigger, I didn’t embrace my newfound affections for Lexmark, which, ironically enough, doesn’t extend to their printer products. Less fortunately, I didn’t think to locate a short in the interim, until a day in which the stars might align, should possibly arrive. Approximately 13 points lower near $37-a-share and reading a more recent story now lost in cyberspace, about attractive low debt / value plays, which Lexmark was a part of (KG, IACI, BBY, MCK, FRX, NVLS), my interest was rekindled. But in this instance, the technical and optionable picture looked, looks a bit more compelling. Well, that is if unconfirmed double-bottom and a negatively skewed reality can be appreciated.

Figure 1: Lexmark ()

Shown above is the monthly view of Lexmark. The pattern potentially taking shape, should recent lows hold, would be labeled an undercut double bottom. Typically, this type of low is considered more robust as the last remaining holders and reversal players attempting the equal bottom play are in theory, relieved of their positions and potential overhead supply is removed. This corner also likes that LXK is testing Bollinger support on this time frame, while flattening out. It’s not perfect, but the idea of extra support for a technical low is generated. Lastly, the daily view (not shown) has been attempting to signal an Elliott Wave 5 completion for about as long as my own bullish gaze has continued to watch shares drop in price.

Figure 2: Lexmark IV / SV

As mentioned, Lexmark popped back up on the radar as some rummaging through Platinum alerted me to a potentially high implieds. However, simply being relatively high doesn’t tell us how the premiums stack up against the actual underlying volatility. For that, pulling up a chart of the IV / SV relationship we can get a better assessment of the theoretical edge. Shown above, we’re seeing how short term premiums line up against longer-term movement. I chose this particular framework, as I wanted to account for the volatility during the steep and durable move lower, while locating a shorter-term position in a still unconfirmed bottom. With that said, premiums are relatively rich compared to Lexmark’s price movement by roughly 30% or a 1.31 reading. That means that theoretically speaking at least, our focus on positioning should be directed towards either short or flat Vega strategies rather than long premium ideas.

Figure 3: Lexmark Put Price / Greek Matrix

Next, bearing in mind the fore mentioned conclusions and preferences towards positioning; looking at September or October premium fit the bill. My choice, however, did gravitate towards the front month. In checking out the options markets, though, it was also realized that any limited risk positioning which looked to also take in the somewhat steep premium, would also need to do so by purchasing a bit of negative skew. But, is that necessarily a bad thing? Not really, if in establishing a position, we can ultimately appreciate the other Greeks and the integrity of what the negative skew really represents.

For instance, shown above are the September 30 and 35 Puts and their associated Greeks. Given a bullish view, were one to put on a Bullish Vertical, it might be executed for .65 cents using mid market prices. That price also represents a slight negative skew. More importantly, though, within the context of selling some juice observed to be high, the spread still accomplishes that as the real meat of the position comes from the 35’s. Yes, we are “paying up”, but .10 cents for crash protection versus a naked sale of the Put for .75 cents and unlimited risk… well, more than 4.35 points and less than 37.18 points—that sounds like skew for pennies on the dollar.

Figure 4: Lexmark Call Price / Greek Matrix

Shown above, a similar decision involving negative Call skew as it relates to the bullish proposition also exists. Here traders might see either a flat Vega Bull Call or perhaps a Long Butterfly which gets us short a small bit of premium as appropriate strategies. In both instances the “paying up” is less severe on an implied basis than in the Puts. Although, depending on a trader’s outlook on the stock, that doesn’t necessarily mean either one is the better choice.

With the Put spread, for instance, LXK could simply continue to stabilize in price and profitability would be attained. At the same time, some upside work would need to be accomplished with both Call strategies. The bottom line remains, though, that for all three situations, the reality of negative skew might be approached a bit more optimistically before any harsh judgments are determined.

Chris Tyler
Staff Writer & Options Strategist
Optionetics.com ~ Your Options Education Site
Visit Chris Tyler’s Forum
 
The information offered here is based upon Christopher Tyler’s observations and strictly intended for educational purposes only, the use of which is the responsibility of the individual.