Does Skewness Matter? Evidence from the Index Options Market

Abstract

Current research on stock returns indicates that neglecting conditional skewness may bias inferences about risk. In this paper, we examine if time-varying skewness in asset returns explains option mispricing. We model the temporal properties of the first three moments of asset returns, and devise trading rules that use skewness forecasts to trade delta-neutral strips, straps and straddles using at-the-money S&P 500 index options. We find that changes in skewness are priced in the index option markets. Our findings are robust to two conditional skewness specifications, two option-pricing models, trading costs and filters. Our results suggest that time varying skewness in the underlying asset returns could be viewed as an alternative explanation to the jump-risk argument to explain option mispricing.

Keywords: conditional volatility, conditional skewness, option pricing biases, at-the-money delta-neutral strips, straps and straddles

JEL Classification: G10, G14