First, as usual, here is this week's link to the Weekly Corn Market Update:

https://www.quartziteriskmanagement.com/weekly-corn-market-update/040921

Also, as promised, a new chart for this week. This chart plots the weekly change in Quartzite's normalized 5-day option skew versus the following week's return. There might be a nugget in here for all of you who enjoy predicting market direction. However, this is a limited data set, and past performance does not necessarily indicate future returns. I do not recommend trading on this information, and it is presented solely as commentary on an interesting market phenomenon.

TLDR explanation: Skew, essentially, reflects the relative supply and demand for upside and downside options. It could be thought of as a contrary indicator, as evidenced by the chart below.

Down the rabbit hole: Many people make a big deal out of put/call ratios, but I think they're flawed, or at least there is probably a better mousetrap. Hopefully, the information below gives you an idea of what that better mousetrap might be.

Option market makers tend to hedge their options positions in a market-neutral manner. Meaning they tend to take opposing positions in the underlying to offset the options positions they accumulate in the process of dealing in options. It would take a whole book to explain this process. Suffice it to say that by doing so, option market makers usually don't care if an option is a put or a call once they've hedged the directional (delta) component. There are some relatively minor differences in some markets, but that's for another time. Here's a quote from an early mentor to illustrate, "Once it's hedged, it's just an option on a line; it doesn't matter if it's a put or a call." Because of this, option market makers often use the words "call" and "put" to describe "upside" and "downside" in their positions rather than actual calls and puts. Such that it wouldn't be uncommon to hear a trader who owned deep-in-the-money puts (properly hedged, of course) to describe his position as "long calls." This statement wouldn't be entirely untrue either. A long put option combined with a long underlying position synthetically creates a long call position (again, there are books on this stuff). I still speak about options this way.

Anyway, another of the early lessons I learned as a market maker, was "You always want the market to go to your shorts." This concept is generally true. Once an options position is hedged correctly, it becomes a ratioed straddle - synthetically. The most basic of options information will tell you that if you own a straddle, you want to go away from it, and if you're short a straddle, you want the market to move toward it. If you have purchased out-of-the-money puts, you might have experienced the converse of my early lesson ("You always want the market to move away from your longs."). Watching the market drift down to your strike while losing on both the put and the underlying is not a pleasant experience. That is, the market went to your longs.

The last two paragraphs mean to bring you to this point. At least to market makers, once an option is hedged correctly, whether it is upside or downside is far more critical than being a call or put. We can see this phenomenon in what is commonly referred to as "skew" by options traders. In its simplest form, skew can be considered the relative price in implied volatility terms of similarly upside and downside options. We could go down a lot more rabbit holes about exactly why skew exists. For now, let's assume it's simply a function of the relative supply and demand for upside and downside options and save the theoretical discussion as to why that relative supply and demand exists for a later date.

The chart below shows the change in our normalized, 5-day, 31-delta-option skew for Dec21 corn futures one week versus the percent change in Dec21 corn futures the following week. "That's great, James, but what the hell is a 'normalized, 5-day, 31-delta option skew?'" I'll explain:

1. Normalized: Since there isn't an expiration every week for Dec21 corn futures, we have to guess. We make that guess by fitting a smooth line between the expirations we can observe in the market and then extending. Once we have that curve, we can estimate the sensitivity of any option (within reason). We build these normalized curves mainly for two reasons. First, we want to assess the downside protection embedded in our clients' crop insurance policies. Second, it allows us to estimate how far the market might move next week and where we might want to rebalance our hedges. See the weekly price levels we publish in the Weekly Corn Market Update for an example. The fact that we can post data like this chart is a byproduct.

2. 5-day: Is as it sounds. These numbers are for theoretical options expiring five trading days from now.

3. 31-delta: Consider these as options struck one standard deviation up and down for the next 5-days. That's not precisely accurate. Still, it's a good enough shorthand for now. In practice, this gives a consistent stake in the ground to compare each week.

4. Option skew: In this case, it is our model volatility for the 31-delta call minus our model volatility for the 31-delta put.

There's so much more to cover, but this is already far too long. I'll leave you with the chart and these last thoughts. The data shown here is the relative change in supply and demand for upside and downside options one week and the percentage change in the futures the following week. Is it predictive? Maybe. Would I trade on it? Perhaps if I was into that sort of thing. Should you trade on it? Not without doing a lot more homework.

Thanks for reading, and let me know if you have any questions comments.

Thanks,
James

Edited (twice) for formatting.

(20210409 Skew vs. Next Week Return (full).jpg)

20210409 Skew vs. Next Week Return (full).jpg (102KB - 158 downloads)