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Volatility Update: A Short Story about Fat Tail Risk

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September 24, 2015
Volatility Update: A Short Story about Fat Tail Risk

Fat tail risk? Yep, you heard that right. Tail risk refers to the possibility that an asset or portfolio moves outside of its typical, or expected, range. Fat tails, especially, can potentially leave the perception that market conditions are more volatile than other signals are letting on.

To be specific, in markets where the distribution of returns is “normal,” a move greater than three standard deviations from current levels has a .03%, or almost zero, probability. During times of market uncertainty, however, portfolio managers become increasingly concerned about downside risk and they may make rattled decisions based on moves beyond what is depicted as a “normal” distribution. In other words, they may perceive the situation as worse than it is; the tail appears fatter and skewed (more on this below).

By this one measure, then, broad stock-market fear reached one-year highs last week and may set up continued volatility moving forward.

VIX Settles Down

The recent drop in the market’s “fear gauge,” the CBOE Volatility Index (VIX), suggests that risk aversions have subsided notably after reaching extremes in late August (figure 1). 

VIX-stock-volatility

FIGURE 1: NEW “NORMAL” FOR VIX.

Recall that VIX hit a high of 53.29 on August 24 before trending lower. It dipped intra-day to the high teens a week ago but moved back up above 20 to start this week. VIX tracks the implied volatility priced into short-term S&P 500 Index (SPX) options and typically moves inverse to broader trends in the equities market. Data source: CBOE. Chart source: TD Ameritrade’s thinkorswim® platform. For illustrative purposes only. Past performance does not guarantee future results.

Distorted View or Dead On?

Meanwhile, skew is the difference in implied volatility across different expiration months and/or strike prices in a specific underlying security like a stock or index. The Chicago Board Options Exchange has created the Skew Index (SKEW) to track the implied volatility of SPX options (like VIX), but on contracts that are very deep out of the money. The index helps measure the premiums that investors are paying for put options that have strike prices well below the current market.

SKEW typically ranges from 100 to 150. At 100, the index generally reflects expectations for normal returns and less chance for an outlier event that might drive the equities market substantially lower. As the index moves above 100, the left tail of the S&P 500 distribution acquires more weight, and the probabilities of outlier returns become more significant, according to the CBOE web site.

Figure 2 shows the spike in SKEW heading into last week’s Federal Reserve meeting. The meeting took place a few weeks after the panic sell-off in the equities market beginning on August 24. The index hit 142.16 ahead of the September 17 Fed meeting, its highest levels in more than a year.

CBOE-volatility-skew

FIGURE 2: HIGHEST IN A YEAR.

The index hit 142.16 ahead of the September 17 Fed meeting, its highest levels in more than a year. Data source: CBOE. Chart source: TD Ameritrade’s thinkorswim® platform. For illustrative purposes only. Past performance does not guarantee future results.

While VIX, the “fear gauge,” was down sharply at Fed meeting time, risk perceptions measured by SKEW remain elevated. One might guess that’s probably because portfolio managers are still a bit skittish heading into the historically volatile stock trading month of October. The SKEW’s lofty readings suggests some portfolio managers may exhibit cautious behavior moving into Q4.

Indeed, as Q3 draws to a close in a week, the earnings reporting season may just test a Fed-sensitive market. Earnings season unofficially kicks off with a report from Alcoa (AA) on October 8.  Manufacturing numbers, monthly payrolls, and a host of other data are sprinkled in for good measure. Keep an eye on changes in SKEW. It’s simply another sentiment measure that could help reveal if the numbers are soothing investor anxiety or if tail risks remain.


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