Most investors are familiar with the VIX Index, but fewer are familiar with its cousin the SKEW Index. The CBOE Skew Index is designed to measure the market’s perception of tail risk – moves with 2-3x the normal standard deviation of returns. Like VIX, it is calculated from the implied volatility of CBOE S&P 500 (SPX) options, but SKEW differs from VIX because VIX attempts to measure the market’s expectation of 30-day volatility using a basket of near and at money options.
It is typical for out of the money options, particularly puts, to have higher implied volatilities than their at-money counterparts. The reason for that stems from demand by hedgers purchasing protective puts and a lack of natural sellers. Out of the money call speculators find much of their demand met by covered call writers, but out of the money put hedgers need to find speculators or market makers who usually must be incentivized by higher implied volatilities to fulfill that demand.
Much had been made of the persistently high SKEW Index, even as VIX was mired in the low teens. Even as the broader indices shot higher, SKEW remained at elevated levels before spiking higher in December. That indicated that there was a high demand for protective puts through year-end. Since its peak on December 20th, SKEW has dropped precipitously, from 150 to 128 as SPX continued higher. This period encompasses the most recent Middle East tensions, during which time SKEW continued to fall. One could interpret the fall in SKEW as increased market complacency.
I decided to look for prior instances when SKEW fell sharply and compare those periods to the movements in SPX. The results are not favorable for investors. At the beginning of 2018 we saw SKEW peak at 138.43 on 12/27/17. Roughly a month later (1/26/18) we saw SKEW down at 117.99 and SPX peak at 2872.87. By 2/8 we had seen SPX correct roughly 10% lower. The ensuing months saw other spikes and drops in SKEW followed by drops in SPX.
Later in 2018 we saw SKEW fall from 151 on 9/18 to 163.33 on 10/3 as SPX peaked at 2925. Within a week of that occurrence SPX was about 7.5% lower before falling further that calendar quarter
However, while these are dramatic examples, there is not enough of a sample size to declare that the current drop is statistically significant. I can’t state with a degree of certainty that the recent fall in SKEW will result in a fall in the broad market. But I can assert that traders who find the current market to be vertiginous might consider the drop in SKEW to be a buying opportunity for protective puts. Contrarian thinking can often be profitable, and nervous investors may want to take advantage of the relatively lower prices for hedges.
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