The Economic Significance of Conditional Skewness Forecasts in Option Markets

55 Pages Posted: 19 Nov 2006

See all articles by Madhu Kalimipalli

Madhu Kalimipalli

Lazaridis School of Business and Economics, Wilfrid Laurier University

Ranjini Jha

University of Waterloo - School of Accounting and Finance

Date Written: October 26, 2006

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.

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

JEL Classification: G10, G14

Suggested Citation

Kalimipalli, Madhu and Jha, Ranjini, The Economic Significance of Conditional Skewness Forecasts in Option Markets (October 26, 2006). Available at SSRN: https://ssrn.com/abstract=943314 or http://dx.doi.org/10.2139/ssrn.943314

Madhu Kalimipalli (Contact Author)

Lazaridis School of Business and Economics, Wilfrid Laurier University ( email )

Waterloo, Ontario N2L 3C5
Canada
519-884-0710 (Phone)

HOME PAGE: http://www.madhukalimipalli.com/

Ranjini Jha

University of Waterloo - School of Accounting and Finance ( email )

200 University Avenue West
Waterloo, Ontario N2L 3G1 N2L 3G1
Canada

Register to save articles to
your library

Register

Paper statistics

Downloads
189
Abstract Views
1,053
rank
160,210
PlumX Metrics