Over the past few years, we have developed a series of indicators of market complacency in order to prevent investors of a sudden spike in price volatility after a long period of calm. One of them looks at the divergence between the Economic Policy Uncertainty EPU index (Baker et al., 2016), a measure of economic uncertainty based on newspaper coverage frequency, and the VIX. Figure 1 (right frame) shows that over the past few years, the EPU index has been displaying a much higher risk level that would be inferred from the options market. Some also watch the activity in the TED spread, which has been distorted since the financial crisis due to a tightening up of regulations and changes in money market funds (figure 1, right frame), and notice when it starts to stir.
Source: Eikon Reuters
An interesting one looks at the behavior of the SKEW index relative to the VIX. As we previously mentioned, since the crash of October 1987 (Black Monday, DJ down 22.6%), investors have realized that S&P500 tail risk (returns that are under 2 or more standard deviations below the mean) is significantly greater than under a log-normal distribution. Therefore, the ‘skew’ measures the perceived tail risk of the market via the pricing of OTM options. A rise in skew indicates that ‘crash protection’ is in demand among institutional investors. A ‘low VIX/high skew’ combination says that the market is complacent, however the ‘big players’ perceive far more tail risk than usually. Therefore, a surprise increase in realized volatility may not be too far away.
Figure 2 shows the times series of the VIX, the SKEW and the weekly change in the SP500. As you can see, a sustain period of falling VIX and rising SKEW is generally followed by a sharp spike in implied volatility. For instance, while the VIX was approaching the 10 level in the summer of 2014, the SKEW index had been on a rise in the year preceding that period, rising from 113 in July 2013 to 146 in September 2014. In addition, the Fed stepped out of the bond market in October 2014 (end of QE3) and therefore exacerbated investors’ concern on the market. We then saw huge moves in both equities and bonds in the middle of that month and the 18-month period that followed was basically a flat equity market with some significant drawdowns (October 2014, August 2015 and December 2015 / January 2016). The second period we highlighted was in 2016 / 2017, which was marked by an extremely low volatility and a rising SKEW. We saw that things reverted drastically in the February VIX-termination event. Following this event, we eventually had another period of falling VIX and rising SKEW in the next months before the October sell-off. We can notice in the chart that the SKEW does not stay above the 150 threshold for too long, hence a VIX trading at around 12 and a SKEW at 150 were last summer were indicating a potential market turmoil.
Source: Eikon Reuters
The SKEW/VIX behavior does not predict a market correction all the time (i.e. the SKEW had been falling for months prior the August 2015 sell-off), however we think that investors should remain cautious when the SKEW starts to rise above 140 and the VIX remains low. While a falling VIX would push investors to increase their leverage (target vol strategies or risk parity funds), we think that looking at the two variables for portfolio construction could help reduce the potential drawdowns.
Last time, we talked about the convergence and divergence between the VIX and SKEW and what sort of information we could get from that. Today, let me introduce you to the VIX/VXV ratio combined with an application on the US Stock market.
But first, let’s start with the definitions of all the indexes:
– As a reminder, the ‘SKEW’ is an indicator that computes the implied volatility of the S&P500 from OTM the options and therefore ‘measures fat tails’ and investors fear.
– The VIX index, introduced in 1993 by the Chicago Board Options Exchange (CBOE), measures the 30-day volatility implied by the ATM S&P500 option prices. The components of the VIX are basically near/next – term put and call options.
– The VXV index (that you can also find in Bloomberg) is designed to be a constant measure of 3-month implied volatility of the S&P 500. It uses the same methodology and generalized formula as the VIX index.
If you are familiar with the term structure, investors and traders can use the historical data of the last two indexes (VIX and VXV) in order to gain a better understanding of the market’s expectations of the future volatility. As you can see it on the graph below, for the past few years (December 11 – June 14), the VIX/VXV ratio (in green) has been oscillating around 0.85 – 0.90 with a low of 0.71 (16-Mar-12) and a high of 1.0645 (02-Mar-14). The ratio has remained most of its time below 1.00, which is logical as the term structure should have an increasing concave shape (in theory). Basically, a ratio superior to one would mean that investors are more concerned about the near term fluctuations (usually a correction) of the S&P500 and often comes from an appreciation of the VIX due to market events such as FOMC meetings or companies’ earnings.
In the graph, we drew a white line which has (‘kinda’) acted as a support for the VIX-to-VXV ratio (around 0.82). However, when we look at the S&P500 chart (white/blue), we can see that most of the times that we hit this ‘imaginary’ resistance, the ratio rebounded and we either saw a stagnation or correction in the stock market.
For those who don’t agree with us concerning the application, they just to have to remember that the VXV provides a valuable tool for traders to identify the term structure of S&P 500 implied volatility and that a single value of the (SPX option) implied volatility is not enough.
Today, we would like to speak about the convergence and divergence between the SKEW and the VIX. We guess that everybody is familiar with the VIX that reflects a market estimate of future volatility (introduced in 1993 by the Chicago Board Options Exchange – CBOE, measures the 30-day volatility implied by the ATM S&P500 option), however let me introduce you to the CBOE SKEW index.
Since the crash of October 1987 (Black Monday, DJ down 22.6%), investors have realized that S&P500 tail risk (returns that are under 2 or more standard deviations below the mean) is significantly greater than under a lognormal distribution. Therefore, the ‘skew’ measures the perceived tail risk of the market via the pricing of OTM options. A rise in skew indicates that ‘crash protection’ is in demand among institutional investors (also called the ‘big players’ in the SPX options market).
A ‘low VIX/high skew’ combination says that the market is complacent, however the ‘big players’ perceive far more tail risk than usually. Therefore, a surprise increase in realized volatility may not be too far away.
If we have a look at the chart below (which represents in fact the VIX and the SKEW), we can see that VIX (green) is sitting at very low levels at the moment (13.57%) and may need to release some ‘energy’. In blue, we have the Skew index which has been fluctuating within the 125 – 130 range for the past few weeks (now trading at 129.25). We recommend you closely watch your positions when the index is approaching the high of the ‘historical’ 100 – 150 range.
If you extend the historical chart since 1990, you can see that the perception of increased tail risk can be early (skew was above 130 level in 2005 already while the VIX was trading at 10.0 at that time), but it definitely remains one the ‘fear’ indicators watched by Wall Street players (with CSFB – Credit Suisse Fear Barometer – index).