Option Skew Points to More Downside Potential in the Nasdaq

NEW YORK (TheGoldAndOilGuy.com) -- By now it is no secret that equity markets continue to deliver solid gains for 2014. In fact, all of the major U.S. domestic stock market indexes are higher for the year. U.S. equities have benefited from an accommodating Federal Reserve, massive corporate stock buy-back plans and solid earnings growth. The bullish trend which began in early 2009 has pushed equity indexes to several all-time highs.

However, when we focus our attention on 2014 one index is showing major relative out performance. The Nasdaq and the Nasdaq 100 indexes have blown away every other major index in terms of overall returns in 2014. The chart shown below illustrates the returns of each major U.S. equity index year-to-date.

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As can be seen above, when looking at the corresponding exchange-traded fund for each major index, the Nasdaq 100 Power Shares (QQQ) is running away from every other major index in terms of performance. As a contrarian trader, I am of the opinion that now may be an excellent time to consider looking for a possible short position to hedge against the bullish trend.

The equity markets in the U.S. are becoming frothy and prices are at the very least fair valued if not overvalued depending on which methods are used to calculate current prices. When we consider the major out performance in the Nasdaq 100 Index, it would only make sense that if we see downside in the future we could capture some big potential profits.

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As an option trader who focuses primarily on probabilities for trade executions using a variety of implied volatility calculations and Delta assumptions, the following observations regarding the Nasdaq 100 Cash Index were derived based on data points on Aug. 29.

Based on the September NDX option expiration date, the current skew in the NDX option data is to the downside. In fact, as I am typing this NDX is trading around 4,075. A 2 standard deviation move to the upside (90%) is around the 4,200 call strike and the same measurement to the downside is around the 3,900 put strike.

When looking at the same data based on the October NDX option expiration date, the current skew in the NDX option data demonstrates more aggressive downside Skew in October versus September. A 2 standard deviation move in the October series to the upside (90%) is around the 4,275 call strike and the same measurement to the downside is around the 3,755 put strike.

While I realize this is somewhat technical, the main premise is that the option market in the Nasdaq 100 Cash Index is skewed toward more potential downside risk. This data lead me to place a new trade earlier this week which was next short the Nasdaq 100 Cash Index using an October call credit spread as a trade structure.

Recent results for the service have been very strong for the options alert service. The last four trades have produced a 13.95% winner in Matador Resources (MTDR) , a 17.05% winner in the S&P 500, a small 1% loss in the Nasdaq 100, and a 21.95% in the Russell 2000 Cash Index

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Ultimately, time will tell if the skew in the NDX proves to work. For now, I like the near-75% probability of success that the NDX call credit spread is offering with a nearly 20% potential return. In the future, expect a recap of this trade.

At the time of publication, the author held no positions in any of the stocks mentioned, although positions may change at any time.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.


TheStreet Ratings team rates MATADOR RESOURCES CO as a Buy with a ratings score of B. TheStreet Ratings Team has this to say about their recommendation:

"We rate MATADOR RESOURCES CO (MTDR) a BUY. This is driven by a number of strengths, which we believe should have a greater impact than any weaknesses, and should give investors a better performance opportunity than most stocks we cover. The company's strengths can be seen in multiple areas, such as its robust revenue growth, good cash flow from operations, expanding profit margins, largely solid financial position with reasonable debt levels by most measures and solid stock price performance. We feel these strengths outweigh the fact that the company has had sub par growth in net income." You can view the full analysis from the report here: MTDR Ratings Report

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