S&P DOOM Volatility Skew Spikes to Multi-Year Highs

Why now is not the best time to load up on SPY "plunge protection"

by Bernie Schaeffer

Published on Aug 20, 2019 at 7:15 AM
Updated on Aug 20, 2019 at 7:15 AM

With the major U.S. equity benchmarks already down more than 3% halfway into the month of August, you don't have to look too far to find signs of panic in this stock market. Witness, for example, the Cboe Volatility Index (VIX), commonly known as the market's "fear index," jumping above the 24 level twice in the past two weeks -- once on an intraday and once on a daily closing basis. At both peaks, the VIX was perched at more than double its April year-to-date closing low of 12.01 -- not to mention the 12.07 "calm before the storm" VIX low close set as recently as July 24.

Simultaneous with the VIX doubling in less than two weeks, the percentage of bears in the weekly American Association of Individual Investors (AAII) weekly sentiment survey doubled over the course of just one week, as of the Aug. 7 poll, to account for 48.2% of all respondents. This 100% increase in pessimism among retail-level traders marked the first time since March 2004 that AAII bears managed to double their ranks on a week-over-week basis.

Yet another sign of extreme fear has emerged from the options pits, where "crash protection" costs on the SPDR S&P 500 ETF Trust (NYSEARCA:SPY) have escalated to their highest point in years. As of last Tuesday, Aug. 13, the 10-day moving average of SPY's 10% out-of-the-money (OOTM) put/call implied volatility (IV) skew rose as far north as 2.192 -- its loftiest reading in nearly four years.

Generally speaking, equity puts are always more expensive to buy than calls, but SPY's 10-day OOTM put/call skew hasn't been in territory this rich since Sept. 16, 2015. That means investors who hedge their long equity exposure via SPY put options are paying steeper premiums now for this "plunge protection" than they have at any other time in the roughly 47 intervening months (which have been reasonably eventful in their own right, to our recollection).

More broadly, 30-day at-the-money IV for SPY options is currently hovering around 16.7%, per Trade-Alert -- in the elevated 75th percentile of its annual range. However, this indicator remains a long way from its Christmas Eve highs, when it topped out at 31.4%. For reference, current SPY 30-day historical volatility (HV) of 20.5% ranks in the 78th annual percentile. Meanwhile, the S&P tracker's 30-day IV skew of 41.4% registers in the 83rd percentile, which confirms that at-the-money put options are also pricing in higher-than-normal volatility expectations relative to their call cousins.

Over the past week's worth of trading in the SPY option pits, we find that the biggest additions to open interest in the newly front-month September series occurred at the 260-, 280-, and 285-strike puts, in descending order, with a total of 77,105 contracts added across these three put strikes in only five sessions. Data from the major options exchanges confirms a strong bias toward buy-to-open activity, including at that "DOOM" ("deep out of the money") 260 strike -- which, even at last week's very lowest intraday tick for SPY, was still nearly 8% OOTM.

The spike in SPY crash protection prices isn't evidence, in and of itself, of climactic levels of fear (although such an argument would be comfortably bolstered by the considerable number of various other sentiment indicators flashing bearish extremes right now), nor does it necessarily herald an impending bottom in sight for the recent downside skid in stocks. In fact, the last time the 10-day moving average of SPY's 10% OOTM put/call IV skew rose this high -- on the aforementioned September 2015 date -- SPY actually went on to plummet 6% over the next nine sessions.

However, it's rather more interesting to observe that the September 2015 signal occurred when SPY (a) had already undergone a correction in excess of 12% from its May closing high of the same year; (b) was on the immediate cusp of a harsh rejection from resistance at its overhead 40-day moving average; and (c) was trading substantially below previously established support at its longer-term 80-day and 160-day moving averages, as well -- firmly in "downtrend mode," so to speak. By contrast, this latest episode of "surge pricing" on SPY DOOM puts took place against the backdrop of a successful catch-and-bounce from the equity tracker's 160-day trendline, leaving SPY to finish the week only about 4% away from its late-July all-time closing high (albeit with the 40-day and 80-day moving averages now overhead).

Given a fundamental picture that includes a protracted trade war with China, ongoing demonstrations in Hong Kong, uncharted territory for the Fed, and periodic reminders that the whole Brexit affair has yet to be resolved, we'll refrain from diagnosing in this space whether the current degree of pessimism in the market is "too much." But for those presently considering the purchase of out-of-the-money SPY puts to hedge long equity exposure, may we suggest that you do so at current IV skew levels only with the fullest courage of your convictions that a short-term crash is imminent.

spy 10-day ma put-call iv skew aug 2019

Subscribers to Bernie Schaeffer's Chart of the Week received this commentary on Sunday, August 18.


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