What pumped skew is telling you about dealers

When skew gets really pumped, it’s telling you something about what end users have already done.

Last week I wrote about pumped skew costing you on a risk reversal. This is the other side of it: what it says about the dealers on the other side of those trades.

Skew only gets pumped like that if end users have bought a load of puts, sold a load of calls, or both.

That means dealers are holding inventory that’s shorter skew than it normally would be, and the vanna sitting in their books is bigger than normal.

That matters if the market actually moves directionally.

The steeper the skew, the faster dealers’ books flip position when spot moves. Even a fairly modest sell-off can be enough to flip them quite short. Once they’re short, their hedging tends to chase the move, selling into the decline. That can make a modest move bigger than it would otherwise have been.

Vanna’s a funny one, because it’s one of the Greeks that means two things at the same time.

How much does my vega change when spot moves?

How much does my delta change when vol moves?

Same Greek, two questions. In a sell-off, both tend to get asked at once. Spot falls and vol rises together, so dealers are re-hedging on both fronts.

The steeper the skew, the more impact vanna has on the market. Positioning is likely quite large, and those second-order Greeks need hedging whenever vol or spot moves.

Reading what the skew says about who’s already positioned, and what dealers will need to do if the market moves, is one of the things I incorporate as part of my framework. What pumped skew is telling you. Where the second-order Greeks start to matter. Why a modest move can turn into a bigger one.

Free 60 minutes, take a look into my framework, linked below.

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