A wise old options trader once told me “option premium is the only real form of equity dividend”. Here is what he meant by that:
- A stock dividend is simply the return of capital you already own as a shareholder. It may signal earnings power and even dampen volatility, but it is not “free money”.
- Option premium – the difference between the option’s price and stock price + time value – is essentially a “free” dividend when you simultaneously own the stock and write call options against it.
One example that makes this point: the ETF QYLD, which both owns the NASDAQ 100 and writes calls against those stocks. The 100 has a 0.7% dividend yield, but QYLD has paid out a 10.6% yield over the last year. You don’t get the NASDAQ 100’s return; QYLD is actually down 5% over the last 5 years. But you do get the options premium, and therefore a much higher “dividend” check every month than owning just the underlying stocks.
Pivoting now to a related topic, let’s look at options “Skew”, which is a measure of the relative price between put and call options. Here’s how the CBOE Skew Index (SKEW), a widely followed measure, works:
- SKEW looks at the implied volatilities imbedded in options prices on the S&P 500.
- The theory here is that as options traders grow fearful of a market decline they will bid up the price of put options. The same will not hold true for call options, since those are more likely to expire worthless as stocks suddenly move lower.
- That means SKEW will rise when options players, typically considered a pretty savvy bunch, see trouble ahead.
So how does SKEW look now versus past market cycles? Here is a chart back to 1990 with 50 and 200 day moving averages:
Here’s what we see in the data:
- SKEW has averaged 119 since 1990 and never fallen below 100, which means options traders ALWAYS put more value on put protection than upside call exposure. The CBOE’s white paper says this started after the 1987 crash, which is a logical conclusion.
- From 1990 to 2013 SKEW ran in a reliable range between 110 – 122. “Fear” peaks happen when you would expect: 1990, 1999, 2006 – 2007 and 2011.
- From 2014 – 2018, however, SKEW shifts notably higher, ranging between 126 – 136.
- In 2019, SKEW has collapsed back to the top of its old range. Average SKEW for October 2019 thus far is 120, although Friday’s close was 126.
And here is what we think it says:
#1: The 2014 – 2018 breakout for SKEW was a lousy predictor of stock market returns, so we have to be careful about using this as a “crisis indicator”. S&P returns over this period: 2014 (+13.5%), 2015 (+1.4%), 2016 (+11.8%), 2017 (+21.6%), and 2018 (-4.2%). Total S&P return over the period: +50%.
#2: Instead, we see some of our old trader’s wisdom about premium-as-dividend in the data. US 10-year Treasury yields fell from 3.0% in early 2014 to a low of 1.4% in mid 2016. Options traders writing more call options to capture “yield” suppressed the price of those instruments while doing nothing to push put prices lower. Since SKEW measures the difference in implied volatilities between puts and calls, it rose over this time.
#3: As for what SKEW is saying right now:
- SKEW’s decline in 2019 is likely due to the Federal Reserve’s easing policy, since the drop coincides with Chair Powell’s January 4th change of heart on rate increases. SKEW peaked for 2019-to-date on January 17th at 133. That made the “Fed Put” relevant again and put prices dropped.
- We would expect SKEW to rise over the rest of 2019 as traders protect gains by buying more put options. There’s no shortage of potential negative catalysts between now and year-end (trade, slowing global economy, Fed policy, etc.), and the S&P still sits just 1.3% off its all time highs.
- At the same time, we’ve shown you that a rising SKEW does not correlate to a falling US equity market.
Bottom line: SKEW is an interesting measure of the options market’s risk assessment, but the internals here mean it is not a robust Buy-Sell indicator for US stocks. Yes, SKEW may well have troughed for the year, but interest rates remain low so call writing isn’t going away any time soon. And put buying should pick up steam between now and January 2020.