Many of you are familiar with the event that took place in 1987, now known as Black Monday, when stock markets across the globe crashed. The CBOE credits the 1987 drop with waking investors up to the idea of market crashes and how we view ‘tail risk’ within the options market. The most common tool used to measure fear in the options market is the Volatility Index ($VIX). The $VIX measures the implied volatility of the S&P 500 over the next 30-days. When the $VIX is low, it’s perceived that traders have become complacent, meaning they are not fearful of a market correction over the next 30-days.
While the $VIX measures ‘likely’ moves within one standard deviation for the S&P, it does not capture what traders are pricing in for ‘tail risk’ or 2 to 3 standard deviation returns below the mean. This is where the Skew Index comes in. Skew measures pricing activity for out-of-the-money options. A trader who expects an abnormally large swing in the equity market could use these out-of-the-money option contracts to hedge or profit from the move. Large institutions make up the bulk of the options market, which can imply that the Skew Index is a way to measure institutional fear of tail risk.
If this is true, then it appears institutions have begun growing increasingly fearful of a subnormal swing in the market. Below is a chart of the Skew Index, with the S&P 500 ($SPX) on the top panel and the Volatility Index ($VIX) on the bottom panel. I’ve put a dotted blue line on the Skew chart to show the current level, as you can see over the last 15 years we’ve only had investors this fearful of tail risk one previous time – March of last year.
It’s interesting to note that while the Vix has fallen to a historically low-level, indicating the market has become somewhat complacent, large investors are showing an increase in the fear of tail risk within the S&P 500.
If you spend time looking more closely at the above chart and the previous high levels in the Skew Index, you’ll notice they often come during short-term market peaks. What’s interesting to note however is that the 2000 and 2007 highs both were put in with low levels in Skew and the Vix. As I’ve stated in previous posts, seasonality right now is bullish, but this large move in institutional fear is interesting and something I’ll be watching in concert with other market internals going forward.
You can learn more about the Skew here: Introduction to CBOE SKEW Index (CBOE)
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Disclaimer: Do not construe anything written in this post or this blog in its entirety as a recommendation, research, or an offer to buy or sell any securities. Everything in this post is meant for educational and entertainment purposes only. I or my affiliates may hold positions in securities mentioned in the blog. Please see my Disclosure page for full disclaimer. Connect with Andrew on Google+, Twitter, and StockTwits.