The Economic Significance of Conditional Skewness Forecasts in Option Markets

Abstract:     
We study the link between option prices and time-varying moments of the underlying asset returns. We focus on the role of conditional skewness for option trading. We model the temporal properties of the first three moments of asset returns, and devise trading rules that use volatility and skewness forecasts to trade in delta-neutral strips, straps and straddles during the period 2000-2002, using at-the-money S&P 500 index options. The out-of-sample analysis indicates that trading strategies based on skewness forecasts are profitable after adjusting for delta risk at long horizons but unprofitable after allowing for trading costs. The use of a more robust skewness option pricing model and forward looking information such as option IVs, along with conditional skewness forecasts lower losses, and result in break-even trading performances after adjusting for trading costs. Our study also provides supportive evidence on the presence of market imperfections, specifically transaction costs, setting limits to arbitrage.

Number of Pages in PDF File: 55

Keywords: conditional volatility, conditional skewness, out-of sample forecasting, option trading

JEL Classification: G10, G14

working papers series