The Chicago Board Options Exchange has just launched a new ‘fear factor’ index to sit alongside the now-famous Vix. Meet the Six, or the CBOE S&P 500 Skew Index.
The ‘SKEW’ is an option-based indicator that measures the perceived tail risk of the distribution of S&P 500 returns at a 30-day horizon. Basically it’s meant to measure what the equity options market thinks about the risk of a black swan event.
Here are some excerpts:
The twisted smile
To understand skew,
think about the volatility smile. Imagine a smiling Mr Vol strolling through the FX and commodity markets, observing on his travels fairly balanced volatility regimes. Now imagine Mr Vol stumbling into the equity option space, being consumed by its fatalistic nature and suffering a stroke down his right side. That smile is now skewed.
Skew is not unique to, but is most commonly observed in, equity options. Société Générale labels it “crashphobia”.
“Lab studies,” SG avers, “suggested that losses are twice as powerful emotionally and psychologically as gains. Reflecting this fear of loss, equity puts are consequently better bid than calls.”
More people want to buy defensive put options for strikes below the present price of an index or stock than want to buy bullish calls. This means the option writers can demand higher premiums for the former.
Plug those premiums into the standard option pricing model and it spits out a reading that the implied volatility of the out-of-the-money puts is higher than that of calls with strikes equally far above today’s price.
In other words, the dear pricing of these popular puts implies that the option writer is at greater risk of having to pay out on the puts than on the calls. The model reads that as saying the underlyings are more volatile on the downside than on the upside.
Let’s use some real numbers. Under the put-call parity theory, at-the-money calls and puts on the same instrument should have the same implied volatility.
For example, a March at-the-money call on the S&P at 1290 has implied vol of 14.7% – and so does the equivalent put.
But further from today’s price, divergence sets in. A 10% out-of-the-money call, on the S&P hitting 1420 in March, has implied vol of 15.0% – only slightly dearer than the at-the-money call. This is one side of the volatility smile.
The opposite put, on the S&P sinking to 1170 by March, has implied vol of 24.6% – a much steeper increase from the at-the-money, giving a skewed smile. Yet both contracts put the writer at risk of a payout if the S&P budges by 10%.
Quite something, eh? Equity option investors are a fearful lot.
Take the vol of the out-of-the-money call, 15%, and subtract it from the vol of the opposite put, 24.6%, and you get 9.6%. That’s today’s (January 25) three month skew on the S&P.
Now watch how that number changes day by day. If it rises, investors are growing more fearful. If it falls, the opposite is true.
Wanted: crystal ball
Come on CBOE. You know what we want. We want an investable index that will predict the future. Is that too much to ask?
So does skew predict the future?
Barclays Capital is on hand to crush our dreams: “One of the urban myths regarding volatility skew that we wish to examine is whether it has any predictive properties, ie. do changes in volatility skew (however it is measured) have any bearing on subsequent market performance?”
The conclusion: “There is no clear empirical relationship.”
So, apart from demonstrating how equity option traders are chicken, what does skew tell us?
Well, it tells us when puts are relatively cheap and expensive. That’s useful for equity portfolio managers. If your portfolio is protected by $500m worth of puts and you have to roll that exposure monthly, you can opt to roll more on days when skew is falling (and puts are cheap) and less on days when it’s rising (and puts are expensive).
Is skew a better indicator, or a better hedge, than the Vix?
Swings and roundabouts… Skew doesn’t rise as much when stockmarkets are falling. So it’s not quite such a powerful hedge as the Vix. Day traders might have less interest in a skew ETF than a Vix ETF.
On the other hand, skew doesn’t fall as fast when markets are rising, making the pain of holding it as a hedge less acute.
Fair enough, sounds interesting, when’s the index being launched?
Sadly, CBOE declines to comment. However, it’s a columnist’s prerogative to speculate. So let me do that.
Much of Casey’s speculation centred on whether the CBOE’s new skew index will be correlated with volatility or not. In other words, whether it will compete with the Vix.
Here’s what he said:
I contend that the Vix and the skew index are complementary, not competing products.
If we see a liquid CBOE skew future trading this side of 2012, I’ll eat my hat. Creating these indices is designed to push more attention towards Vix – the golden goose.
CBOE has successfully entrenched a common understanding of what implied volatility is. It is the Vix. To protect that success, CBOE wants ancillary indices to help sophisticated investors further understand when and why to take opportunities in trading the Vix.
In other words, the CBOE is creating indices that say “TIME TO TRADE THE VIX” every day in every way. It’s a smart move, and maybe it says something about where this company goes next.
Lo and behold — this week’s CBOE press release heralding the arrival of the Six, or SKEW, states “SKEW and VIX indexes are different, yet complementary measures of risk.” You can see the ‘complementing’ more clearly in the below CBOE chart:
Looks like the Six suffers from the same discrepancies in relation to the Vix that have plagued some previous attempts at skew-based indicators.