Dangerously Askew - Real Time Insight

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Building on the option pricing basics we talked about in VIX: 7 Things You Need to Know , today I introduce the concept of skew 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 skew.

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 or index.

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 the "skew".

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 stocks.

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 crash?

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Stocks

Referenced Stocks: IWM , VXX

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