Building on the option pricing basics we talked about in
VIX: 7 Things You Need to Know
, today I introduce the concept of
that is flashing a big warning signal for equity markets right now.
The chart below will give you the visual, but let me first explain
The CBOE calculates a SKEW index on S&P 500 index options, the
same options that create the VIX. The SKEW index is a measure of
how much more expensive downside index options are than upside ones
on a relative "implied volatility" (IV) basis.
What it measures, in plain English, is how much more institutional
players are paying for low-priced "out-of-the-money" (OTM) put
options (those with strikes below the current index price). The
more they pay for OTM puts, on a relative basis, the more they
probably fear the need for protection.
Skew is universal in options and part of the 3-dimensional way of
describing the "surface" of volatility. As option professionals
analyze implied volatility (IV) across time, i.e. different
expirations, they also do so across strike prices in the same stock
At-the-money (ATM) options will generally have the lowest IV while
OTM options will generally have higher IV. So when option traders
plot a price chart of IV (y-axis) across strike prices (x-axis), it
ends up looking like a trough, or a bell curve flipped upside down.
It is normal for the left side of such a graph to have higher IV
prices because the downside is where the most perceived "tail" risk
exists in financial instruments. And the left side is where the
less-costly OTM puts exist.
But if we track skew over time, especially for indexes like the
S&P 500, then we can see general patterns of pricing that may
be an excellent guide to extremes on the "complacency vs. fear"
spectrum among institutional hedgers.
Here's a good recent look (as of July 8, 2014) at historical SKEW
extremes, courtesy of Dana Lyons at RIA J. Lyons Fund Management...
Here's how the
CBOE SKEW site
describes this important tool...
SKEW typically ranges from 100 to 150. A SKEW value of 100 means
that the perceived distribution of S&P 500 log-returns is
normal, and the probability of outlier returns is therefore
negligible. As SKEW rises above 100, the left tail of the S&P
500 distribution acquires more weight, and the probabilities of
outlier returns become more significant. One can estimate these
probabilities from the value of SKEW. Since an increase in
perceived tail risk increases the relative demand for low strike
puts, increases in SKEW also correspond to an overall steepening of
the curve of implied volatilities, familiar to option traders as
And here's what Dana Lyons tweeted this morning...
"Something's Askew: Of the 21 CBOE Skew readings > 138.5 from
1990-2014, 8 have come in the last 3 weeks"
Conclusion: while the VIX remains subdued and stocks flirt with
all-time-highs, the SKEW is saying that big players are quietly and
eagerly buying up put protection while they hang on to their
How useful do you find this tool? Does it concern you about the
market's perceived risk of a sudden melt-down, or the proverbial
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