Saturday, July 19, 2014

SKEW Index predicting financial peril ahead


CBOE to Begin Publishing Values for CBOE S&P 500 Skew Index Introduction to CBOE SKEW Index ("SKEW")

The crash of October 1987 sensitized investors to the potential for stock market crashes and forever changed their view of S&P 500® returns. Investors now realize that S&P 500 tail risk - the risk of outlier returns two or more standard deviations below the mean - is significantly greater than under a lognormal distribution. The CBOE SKEW Index ("SKEW") is an index derived from the price of S&P 500 tail risk. Similar to VIX®, the price of S&P 500 tail risk is calculated from the prices of S&P 500 out-of-the-money options. SKEW typically ranges from 100 to 150. A SKEW value of 100 means that the perceived distribution of S&P 500 log-returns is normal, and the probability of outlier returns is therefore negligible. As SKEW rises above 100, the left tail of the S&P 500 distribution acquires more weight, and the probabilities of outlier returns become more significant. One can estimate these probabilities from the value of SKEW. Since an increase in perceived tail risk increases the relative demand for low strike puts, increases in SKEW also correspond to an overall steepening of the curve of implied volatilities, familiar to option traders as the "skew".


Put simply, there is no tail risk when SKEW is equal to 100 or lower. SKEW can be used to gauge the probabilities of returns two and three standard deviations below the mean. If SKEW is close to 100, the probability of a steep market decline remains very small, however if SKEW rises above 100, the probability increases. We are currenlty at the 142 range. 

The last time SKEW reached its all time high of 146.88 was on Oct. 16, 1998 when we were in the midst of the Russian crisis, and the day after the decision by the Federal Reserve Board to decrease both the target federal fund rate and the discount rate. The SKEW index also rose in March 2006 when many were concerned about the housing market crisis. 


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