The OTHER S&P 500 Vol Measure

Hey Traders,

If you read my VIX Edge newsletter (which you should …) you may have heard me talk about SKEW a few times recently.

But what exactly IS SKEW? 

What’s the difference between SKEW and skew?

And what does SKEW tell us about the market?!

Don’t Skew SKEW

First of all, SKEW refers to the CBOE SKEW Index (Ticker: SKEW), while skew (lowercase) is actually a measurement of the cost of out-of-the-money (OTM) puts relative to out-of-the-money calls.

This is often called the “volatility smile” or “volatility smirk” because of the way it looks on a chart. Take a look at the skew curve for Tesla (Ticker: TSLA) January 2022 options:

In a perfect world, the demand for puts and calls would be equal, and thus the chart would be symmetric. This is typically not the case, though.

Because there’s typically more demand for OTM puts (since they are frequently used to hedge) the implied volatility priced into OTM puts is usually higher than the implied volatility being priced into OTM calls, giving the put side a much steeper slope.

You can see a steeper skew curve by looking at November SPX options:

You’ll notice the slope of the left side of the graph, which measures the implied volatility (IV) of OTM puts, is steeper than the right side, which measures the IV of OTM calls.

It is the steepness of this slope that we want to pay attention to, as it shows us the demand for protective puts among options traders.

The CBOE SKEW Index (Ticker: SKEW) also tells us something about implied volatility and the demand for protective puts.

SKEW measures the IV of S&P 500 (Ticker: SPX) options.

This might sound familiar, as the VIX also measures IV of SPX options, but the two are actually quite different.

While the VIX looks at implied volatility being priced into any S&P 500 with open contracts, and gives more weight to contracts with more open interest, the SKEW Index looks at crash protection puts: puts that are used to protect portfolios against “black swan” events that would cause a sudden and dramatic market crash, otherwise known as the “tail risk” of the SPX over the next 30 days. 

“Tail risk” events would involve the market seeing returns two standard deviations or more outside of the mean, so near-the-money options, or even reasonably far-out-of-the-money options, are not factored into SKEW.

The more traders are hedging against tail risk, the more demand for very-out-of-the-money options, and thus the higher the implied volatility being priced into these options.

SKEW typically reads between 100 and 150, with 100 indicating a low expectation of outlier events, and a higher reading indicating that there is more demand for these protective crash puts.

Now, you might think that a higher SKEW would correlate with a higher VIX. After all, they’re both telling us about the IV of SPX options, and thus trader sentiment, right?

Actually, the way we interpret their messages is different than you might expect.

For one, while VIX has typically had a negative correlation with returns of the SPX …

There is a high correlation between steep SKEW index, and positive market returns!

Why?

Well, if I’m expecting a market crash, am I going to hedge with cheap, far-out-of-the-money puts, like those measured by SKEW?

No.

More likely, I am going to pay more for a better, less-far-out-of-the-money hedge that will give me a better chance to profit.

So demand for far-OTM puts actually indicates there is less of an expectation of an impending outsized market move.

These are more “just in case” puts than “I think the market is going down” puts.

Now take a look at the six-month chart of the SPX:

And compare it to the six-month SKEW chart:

At first glance, there may not seem to be too much direct correlation …

But if you compare the peaks of SKEW to price action in the SPX, you’ll see that many of the SKEW spikes correspond with the SPX making a move higher.

Of course, this is far from a 100% correlation, but it does make SKEW an interesting sentiment indicator that isn’t always what it appears to be on the surface.

Also, take note of the relationship between SKEW and VIX.

As you can see in these two-year SKEW and VIX charts, the two sentiment indicators do not really mirror each other much at all. 

Two-year SKEW chart

Two-year VIX chart

In fact, as the VIX reached its peak of 82.69 on March 16, 2020, SKEW was at 114.66 — among its lowest readings ever.

The SKEW hit its own all-time high on June 25, 2020 … as the VIX was hitting a (then) post-pandemic low of 15.62.

Right now, with the VIX in the low 15’s, SKEW is sitting at 141.30.

This higher SKEW reading actually reads as bullish … as does the low VIX.

Taken together, these two sentiment readings use similar stats to give us very different messages on trader sentiment …

And a clearer overall picture of the market.

Your Only Option,

Mark Sebastian


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