Given the wild ride the markets have taken us on over the past several decades, many investors and traders have developed a fixation on tail risk.
That’s a fancy way of saying there’s a permanent demand for plunge protection that option traders call the “skew.” In statistician’s parlance, tail risk typically refers to price moves two or more standard deviations above or below the mean.
In options markets, this phenomenon often means put options are more expensive than call options.
To keep track, traders use the Chicago Board Options Exchange’s SKEW Index, which is derived from the prices of out-of-the-money options linked to the Standard & Poor’s 500 Index. Last year offered a good lesson, as several episodes of high volatility sent SKEW readings toward record highs.
SKEW typically ranges from 100 to 150, with 100 signaling the perceived distribution of S&P 500 returns is normal and there’s only a negligible probability of a tail-risk outlier return from a major, market-moving surprise.
But as SKEW rises above 100, the probabilities of an outlier return become more statistically significant. Simply stated, more perceived risk equals more demand for protection.
Here are two things to consider regarding the current state of the CBOE SKEW Index:
Since 1990, the level of “skewness” has consistently increased, as shown by the regression slope in figure 1. This means investors are structurally increasing protection activities. This may be because investors are becoming more informed, or because they have more access to options markets.
The SKEW index has reached an extreme 140 level in only a handful of periods. During these periods, the cost of out-of-the-money puts has been the most expensive relative to their call counterparts.
Historically, extreme SKEW hasn't lasted long, as the market has found equilibrium eventually. However, in 2014, skewness has persisted around 140 much more than in earlier periods (at the close of trading January 30, the end of a tumultuous week in which the S&P 500 sank nearly 3%, the CBOE SKEW was about 130).
The record levels of skewness in 2014 aren’t surprising given the global economic and political climate. Also, many investors and traders “chasing” yield have been selling call options, which contributes to depressed call prices.
Other investors have been counting the age of a historic bull market and bidding up put option prices in hopes of protecting their profits, all of which is pushing the skew toward the extreme.