The Economic Significance of Conditional Skewness in Index Option Markets

Abstract

This study examines whether conditional skewness forecasts of the underlying asset returns can be used to trade profitably in the index options market. The results indicate that a more general skewness-based option-pricing model can generate better trading performance for strip and strap trades. The results show that conditional skewness model forecasts, when combined with forward-looking option implied volatilities, can significantly improve the performance of skewness-based trades but trading costs considerably weaken the profitability of index option strategies.

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

JEL Classification: G10, G14