Negatively Skewed Trading Strategies

1. Two stocks A and B

A - mean return 1%, skew of return PDF -2%, hit rate 50%
B - mean return 0.8%, skew of return PDF 0, hit rate 50%

You have 100 dollars. Which one you should invest in?

One can think of skew in relation to volatility in the same way one thinks of acceleration in relation to speed. It is not enough to know your speed when driving but also whether you are capable of decelerating when approaching an obstacle and accelerating when you need to.

Positive skew is the ability to have lower volatility than average when losing money and higher volatility when making money. Negative skew is the opposite; it is the characteristic of having higher volatility than average when losing money and lower volatility when making money.

A set of returns made up of frequent small, lower than average, returns and occasional large gains would be positively skewed. Conversely, a set of returns with frequent small, above average, returns and occasional large losses would be negatively skewed.

One additional characteristic of skew that must be mentioned is its invariance with respect to volatility, (i.e., the value of skew for a set of returns stays unchanged if all the returns are multiplied by a constant.)