A popular options-market gauge of so-called black swan, or difficult to predict, events is drawing the attention of some bears on Wall Street as it trades at record levels.
The CBOE Skew Index
or simply Skew, which measures the relative cost of purchasing out-of-the money put options on the S&P 500 index
finished at a record of 153.34 on March 17, and maintained that level on Monday. Put options confer the right, but not necessarily an obligation, to sell an asset at a specific price and time, while calls give the owner the right to buy an underlying asset (see chart below of the S&P 500 compared with Skew levels):
Skew essentially offers a way to gauge relative demand from investors interested in purchasing insurance—or hedging their equity exposures—against a possible downturn in the broader stock market. Put another way, Skew tracks bearish options bets on the S&P compared with bullish wagers of similar duration, and by some interpretations, investors are now aggressively betting that risks are growing.
Stocks have been on a tear in the wake of President Donald Trump’s Nov. 8 election, which invigorated what some described as the market’s animal spirits. Since the election, the S&P 500 has climbed more than 11%, the Dow Jones Industrial Average
has gained 14% and the Nasdaq Composite Index
has climbed about 13.6% during the same period.
But over the past several sessions, Skew’s rise has coincided with a decline, if not a stall out, of the S&P 500 and the broader market.
Read: The S&P 500 and Dow have now gone 109 days without a 1% decline
Skew has climbed in fits and starts since late January and is up more than 21% so far this year, according to FactSet data.
“I think this rise in Skew reflects demand for hedging of broad-market exposure after we have been setting new highs at a record pace,” said Mark Longo, CEO of Chicago-based research firm OptionsInsider.com.
“We see that investors are more concerned about downside protection,” he said.
The rise in Skew also comes as Wall Street’s fear gauge, the CBOE Volatility Index
has traded well below its historic average of about 20 for a protracted period, implying a market that may not be prepared for a sudden market swing.
Russell Rhoads, director of the Chicago Board Options Exchange’s Options Institute, said that a higher Skew does mean that out-of-the-money puts are relatively expensive—due to increased demand—but said that context is important to consider. “In a low volatility environment, we may get excited about an all-time high, but keep that number in a bit of context,” Rhoads said, suggesting that the lower levels for the VIX may make it more prone to climb.
Jason Goepfert, president of Minneapolis-based investment research firm Sundial Capital Research, tracks Skew in relation to the VIX. He said when Skew climbs this far above the VIX, a downturn has tended to follow in the next 30 to 60 days:
“Historically, when we have seen an extreme in the relationship between the SKEW and VIX, the S&P moves in the opposite direction over the next 1-2 months,” said Goepfert, who publishes Sentimenttrader.
To be sure, there are many interpretations of the recent rise in Skew. Perhaps the simplest one is that the price to buy insurance against an equity decline had gotten so cheap, it triggered a buying stampede that pushed prices higher.
Investors faced a veritable gauntlet of potential risks last week, including the Federal Reserve’s decision to lift benchmark interest rates a quarter-point for the first time in 2017, as well as concerns about the outcome of a Dutch election, which could have confirmed the rise of populism in Europe—potentially disruptive to the eurozone and the euro
Those events passed without much drama, but investors may now be viewing France’s presidential election in the coming months as another potential dose of geopolitical volatility.