Are Options Underpricing the Probability of More Upside?

Yesterday, we noted that the humans rarely "predict" that volatility will go lower. And that "prediction" makes some sense given that the markets themselves rarely predict lower volatility.

I used CBOE Volatility Index (VIX) premiums to realized volatility and VIX futures premium to VIX itself as examples. But there are more ways to gauge expectations out there. I bring you, SKEW -- courtesy of Chicago Board Options Exchange (CBOE):

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 and concerns, SKEW would be close to 100.

The CBOE SKEW Index hit 146.08 on Sept. 19, 2014, its highest level since 1998.

The average daily closing levels for the CBOE SKEW Index were --

> 129.4 in 2014 (through November 17),

> 117.2 in the 24 years from 1990 through 2013.

SKEW compares the implied volatility of out-of-the-money puts to out-of-the-money calls. Thus a reading of 100 would mean the fear of a dip is about equal to the fear of a rip.

Spoiler Alert: SKEW doesn't dip below 100, though it would likely hover around there around a crash. It got as low as 110 in 2008.

It's interesting that SKEW has acted so well in 2014. Volatility as measured by VIX has remained very blah this year, save for the relatively brief February and October spikes. It's averaged about 14 -- coincidentally where we sit right now. SKEW, however, has had a veritable boon.

One way to look at it is that there's excessive fear of a downside "tail." But another is that there's very little "fear" of an upside pop. Mentally, I believe we look at this like the near-the-money options are "fair" and the out-of-the-money puts are on the high end -- ergo, the "tail" hedge. But what if instead we centered our universe on the "tail" hedge and called those options fair? That implies at-the-money options are cheap and out-of-the-money upside options are extremely cheap.

Viewing the whole picture from that angle suggests there's some serious under-pricing of the possibility of more upside. Maybe over-writing calls has become too easy a trade? The biggest risk of a buy-writing strategy is foregone upside (remember, you already own the stock). With realized volatility incredibly low, especially in rally phases, there's not much cost associated with writing and rolling calls. So why not keep doing it?

I'm not predicting any sort of rip. I'm just saying a low VIX/high SKEW combo suggests that options players, net-net, might be underpricing the probability of a strong rally from here.

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