Schaeffer's Trading Floor Blog

What This Rare Reading May Be Spelling for Markets

The CBOE SKEW Index is lingering in levels not seen since late 1998

by 7/1/2014 7:40 AM
Stocks quoted in this article:

Mind if I ask SKEW a question?

What's SKEW? I don't know, what's SKEW with you?

… OK, sorry, no more horrible jokes.

I bring up SKEW because as the Chicago Board Options Exchange (CBOE) notes, we're seeing lots of it right now.

This past Friday (June 20) the CBOE SKEW Index rose to 143.26, its highest level since Oct. 16, 1998.

Actually, what is SKEW you ask? Well …

CBOE SKEW Index values, which are calculated from weighted strips of out-of-the-money S&P 500 options, rise to higher levels as investors become more fearful of a "black swan" event -- an unexpected event of large magnitude and consequence. The value of SKEW increases with the expected tail risk of S&P 500 returns. If there were no tail risk expectations, SKEW would be equal to 100. Historically, SKEW has varied in a range of 100 to 147 around an average value of 115.

It's basically an index of out-of-the-money (OOTM) puts versus OOTM calls. The higher it gets, the higher the relative premium on OOTM puts. And, as the CBOE demonstrates, we're at 15-and-a-half-year highs.

My first reaction is that it makes some sense that SKEW would rise in a low-volatility backdrop. Everyone loves cheap dollar plays that hedge or speculate on tail "events." And when they do buy those pups, it's more about the dollars spent on the play, rather than the implied volatility of the options. Whether it's far OOTM puts in the S&P 500 Index (SPX) or far OOTM calls in the CBOE Volatility Index (VIX), who doesn't want to buy lots of 25-cent long shots, and have them double or triple at the slightest hint of danger? It's always a popular play.

Conversely, it's not particularly in vogue to buy cheap upside calls after a long and slow rally. Nor is it popular to even buy at-the-money (ATM) options these days. Since SKEW relates all this in volatility terms, it makes sense to me that it would run high now.

But does that high SKEW mean anything as far as the market looks going forward?

Well, there's three possibilities. One is that it's "smart" money buying protection ahead of a choppy future. I find this the least likely explanation. This same "smart" money has bought and rolled countless cheap-dollar VIX calls and paid premiums for VIX futures for pretty much the entirety of the rally. They'll catch the turn at some point, but there's no probability in declaring this -- right here, right now -- is THE moment.

Possibility two is that it's a good contra tell. Everyone obsesses over the lack of fear that the low VIX represents. But, as we note over and over, the constantly upsloping VIX term structure is a sign that there's more fear than meets the eye. This SKEW is consistent with that. I'd side more with this indicator as a contra tell than a leader.

Possibility three is it doesn't mean a whole lot -- it's a quirk of math around a low VIX.

I'll vote somewhere between two and three. I don't believe a high SKEW in this particular backdrop means a whole lot. I always find evidence of non-belief in a rally as modest bullish tell on the margins, but this particular case is really out on the margins, in my humble opinion.

Disclaimer: Mr. Warner's opinions expressed above do not necessarily represent the views of Schaeffer's Investment Research.


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