SKEW Goes Pear-Shaped
Back in 1998, at the height of the Russian crisis, the CBOE SKEW Index reached its all time high of 146.88. Previously very high values were seen on the eve of the 1990 recession, and in March 2006 it spiked again when sudden worries about the housing bubble surfaced.
“There are no black swans” they said …
Over the past two years, SKEW has begun to act totally crazy, regularly rising to rarely before seen levels. In late 2014 and again in September this year, moves to around the 140 level have become quite frequent. On Tuesday it broke its Russian crisis all time high, spiking briefly to 148.91.
“What the hell is SKEW?” we hear you ask. Here is the explanation from the CBOE, where SKEW lives (or rather, where the options that are used in its calculation live):
“The CBOE Skew Index – referred to as “SKEW” – is an option-based indicator that measures the perceived tail risk of the distribution of S&P 500 log returns at a 30- day horizon. Tail risk is the risk associated with an increase in the probability of outlier returns, returns two or more standard deviations below the mean. Think stock market crash, or black swan. This probability is negligible for a normal distribution, but can be significant for distributions which are skewed and have fat tails. As illustrated in the chart below, the distribution of S&P 500 log returns has a sizable left tail. This makes it riskier than a normal distribution with the same mean and the same volatility. SKEW quantifies the additional risk.
SKEW is derived from the price of S&P 500 skewness. That price is calculated from the prices of S&P 500 options using the same type of algorithm as for the CBOE Volatility Index (VIX). The details of the SKEW algorithm and a sample calculation are presented in the SKEW White Paper http://www.cboe.com/SKEW .
The value of SKEW increases with the tail risk of S&P 500 returns. When there is no tail risk, SKEW is equal to 100. Historically, SKEW has varied in a range of 100 to 150 around an average value of 115. […] Close to 100, the probability of a steep market decline remains very small. As SKEW rises above 100, this probability increases.
SKEW and VIX are different and complementary measures of the risk of 30-day S&P 500 returns. VIX is a close proxy for the standard deviation of those returns. The standard deviation describes the average spread of the distribution of returns around its mean. This is not a sufficient measure of risk because the distribution of S&P 500 log returns is not normal. SKEW describes the tail risk of the distribution. The daily values of SKEW and VIX are uncorrelated, but the range of SKEW tends to narrows for extreme values of VIX.
If this sounds like someone is looking for a black swan to enter the scene from stage left, you are on the right track. Essentially, a sharp rise in SKEW is telling us how the perceptions of investors trading SPX options with respect to tail risk are evolving. Historically, SKEW will often spike long before this tail risk is actually realized, but occasionally the timing is closer.
A Spot of VIX Strangeness for Good Measure
On Tuesday, another slightly strange thing happened. With stocks barely negative by the close, the VIX rose quite a lot in percentage terms – a lot more than one would normally expect. It already opened quite strongly.
VIX vs. NDX and SPX, intraday 5 minute candles – focus on yesterday’s action on the left hand side. At the open the VIX was already a full point above its closing level of Monday. It then dipped back to nearly unchanged when the market rose in early trading, but thereafter rose steadily to end the day with a plus of more than 1.7 points. This was certainly an outsized move for such a quiet trading day – click to enlarge.
Presumably the firm VIX and the unusual move in the Skew Index were connected. The upshot is that someone has been bidding up near term SPX options that hedge against tail risk.
None of this may mean anything of course. As noted above, spikes in SKEW have often been observed in the past with a considerable lead time to tail risk actually becoming manifest. Given that the earnings season is underway, it is possible that someone has hedged a large portfolio because this quarter’s earnings season is seen as riskier than usual.
However, it is always possible that whoever is betting on emerging tail risk here knows something we mere mortals don’t know (yet). We would also note that the gold price is remarkably perky of late, for no immediately obvious reason. There are reasons of course, several in fact – such as widening junk bond spreads, a decline in the relative strength of bank stocks, fresh geopolitical risks due to Russia’s intervention in Syria, a weakening US economy, etc. – but none of them have hitherto mattered much to the markets. If they do begin to matter, it would mean we are witnessing a character change – in which case the sudden spike in SKEW would certainly make sense as well.
Charts by: BarChart, StockCharts