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Volatility Update: Options Skew Requires Look Below the Surface

February 18, 2016
Stock volatility watchers are on edge: CBOE Skew Index

Volatility surged across financial markets through mid-February. Crude oil touched 12-year lows. The once high-flying U.S. dollar has pulled back. And gold has rallied from $1,060 an ounce at the start of the year to nearly $1,250 an ounce. Treasury bonds have drawn buyers spooked from higher-risk corners, driving the yield on the benchmark 10-year note to two-year lows below 1.7%. And among the most volatile? Stock markets at home and abroad.

The S&P 500 (SPX), for instance, is down 10.5% year to date through February 11, setting fresh one-year lows. The drop again stirred the CBOE Volatility Index (VIX), the stock market’s “fear gauge.” VIX wrapped 2015 at 18. It tickled 30 in recent sessions and has trended in the upper to mid-20s so far 2016 compared to an average reading of 16.7 last year (figure 1).

VIX challenging 30


This one-year view of the CBOE Volatility Index (VIX) shows the “fear gauge” averaging in the mid-20s so far this year, nearly 10 points above its 16.7 average in 2015. Data source: CBOE. Chart source: TD Ameritrade’s thinkorswim® platform. For illustrative purposes only. Past performance does not guarantee future results.

Since the CBOE Volatility Index tracks the implied volatility priced into short-term SPX options, the higher readings in 2016 suggest that premiums to buy put options and call options are getting relatively more expensive, right? This sometimes happens when investor sentiment turns skittish and there’s increased demand for SPX puts to offer a degree of short-term portfolio protection.

Tail Wagging the Dog?

Yet, while VIX is ticking to 2016 highs, not all measures of volatility are following suit. Looking at the CBOE Skew Index (SKEW), for instance, paints an interesting picture. Developed by the Chicago Board Options Exchange, SKEW reflects the premiums of deep out-of-the-money options that are outside of the normal range. It’s the VIX for deep downside puts, if you will (puts with strikes well below the current market price).

By definition, SKEW measures the increase or decrease in premiums for options that lie outside of two standard deviations (or greater) from the mean. It’s an indicator of how much portfolio managers are paying to hedge the so-called “tail risk” or, in simpler terms, to protect portfolios from the possibility of a substantial market decline, i.e., crash

stock option volatility skew


A daily SKEW chart shows a noticeable decline in 2016. Yes, even as the S&P 500 is falling to one-year lows, the SKEW is falling to levels not seen since late September—just before SKEW saw a major spike to new highs of 151.14 during a dramatic market sell-off. Data source: CBOE. Chart source: TD Ameritrade’s thinkorswim® platform. For illustrative purposes only. Past performance does not guarantee future results.

Fleeting Feeling?

The SKEW is typically between 100 and 150 (figure 2). A reading of 100 typically means that the perceived distribution of S&P 500 log-returns is normal and the probability of outlier returns is therefore negligible, according to the exchange. As it moves above 100, it suggests that demand for lower strike puts is increasing and there is an increase in (tail) risk perception.

Yet, during the recent market decline, SKEW has been falling. Maybe this is a sign that some portfolio managers expect the recent period of market volatility to be fleeting and that the risks of a substantial market decline are diminishing? Time will tell, of course, because as we all know, risk perceptions can and do change quickly. 

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