Contrarian options strategy using volatility skew

Today's focus is on implied volatility skews and the potential trading opportunities derived by our scans. Scanning our universe of stocks we have assembled the following watch list:

Stock Symbol Skew Reading Option Interpretation
DD Dupont 1.08 Calls greater than Puts
BIDS 1.06 Calls greater than Puts
PFE Pfizer 1.05 Calls greater than Puts
SHW Sherwin-Williams 1.05 Calls greater than Puts
ED Consolidated Edison 1.05 Calls greater than Puts
AOL America OnLine 1.05 Calls greater than Puts
MRK Merck 0.94 Calls less than Puts
SLB Schlumberger Ltd. 0.94 Calls less than Puts
GE General Electric 0.93 Calls less than Puts
NMK Niagara Mohawk 0.92 Calls less than Puts
SYY Sysco Corp 0.90 Calls less than Puts
SPX S&P 500 Index 0.90 Calls less than Puts
CG Columbia Energy 0.87 Calls less than Puts

Skews for most individual stocks are normally non-existent. The lack of a skew or a neutral reading of around 1.00, suggests that there is no strong overriding bias for either call or put options by market participants. However, occasionally you do see the market for a particular stock's calls or puts get out of alignment. This is due to either a bidding up of one type of option, a selling of the other type of option or a combination of those activities. However, when a skew situation exists there maybe a reasonable explanation for it- (a takeover rumor, a product announcement, a legal decision, etc) so check the news. However, if there is no news there may be a trading opportunity because the market has simply got ahead of itself.

As mentioned earlier in our writings, a trading opportunity can arise due to this type of sentiment play. In this concept, contrarian investors look toward various trading data for ideas in which to go opposite of the crowd's opinion. We may have some contrarian ideas here today courtesy of our skew scan. What is interesting is that the SPX yesterday and again today have signaled that investors are negative on the market. Yesterday's and today's readings show that option players are leaning toward the put side (down side) and may have been caught off guard by yesterday's activities. We'll see if it continues today as well.

Another interesting way to interpret the skew data is to assume that if a stock has a big call skew (people looking for the market to rise) and in excess of 1.05, then in an upmove the stock may underperform. This is due to the fact that most people already have the long stock position in place and no further buying is foreseen. Subsequently, further rises may only see selling as option holders take profits thus limiting the stock's rise. On the other hand, in a down market move, the stock may fall more violently because the long call positions are liquidated adding further pressure to a weak market.

Conversely, a stock that has a skew reading below 0.95, implies that there are more puts being bought than calls and a bearish move is expected by market participants. In this type of situation, a market down move may see this particular stock hold up and not fall as drastically as the rest of the market. Again, this can be explained by the fact that most of the market's participants have already sold and there is little expected follow through selling expected. Instead this particular stock may see buyers looking to close out their positions and take profits on their short stock (long put positions) views.

Meanwhile in an upmove, stocks with this type of configuration may actually outperform the rest of the market. This is because as the market rises participants' short views get squeezed and option hedges get lifted-fueling the fire and the move to the upside.

Looking for clues on where the S&P 500 and the rest of the market is going today?
Watch the following two stocks for clues Xilinx (XLNX) and Conexant Systems (CNXT) they have the highest correlation to the S&P 500 Index today with readings of 84.52 and 83.06 respectively.

Final Volatility Thoughts
Watch the following Dow Jones Industrial stocks for volatility moves today as they make-up our list of most overbought and most oversold implied volatility stocks.

Stock Symbol Reading
EK Eastman Kodak 122.49
HD Home Depot 118.33
GE General Electric 113.46
JPM JP Morgan 112.78
MSFT Microsoft 64.95
PG Procter & Gamble 64.22
T AT&T 63.12
UTX United Technologies 58.33

Good luck trading today.