There is an inherent tension in the stock market right now, on the one hand volatility remains at historically low levels, while on the other the amount of downside protection being bought is rising sharply. We question whether this hedging activity could actually be the canary in the coalmine for the US indices, and once hedging gets to an excessive level if it becomes a self-fulfilling prophecy.
The Vix vs. the CBOE Skew index
The tension in the market can be seen in clearly in the chart below. The white line is the Vix, while the green line is the 50-day moving average of the CBOE skew index for the S&P 500.
While the Dow and the S&P 500 eke out further gains, this stage of the rally can be quite tumultuous for investors who don’t want to cut their trades too early and miss potential profit opportunity, but equally they don’t want to be the wrong side of a major event that causes stocks to sell off sharply.
The Skew index is derived from the price of S&P 500 tail risk, which measures the risk of outlier returns two or more standard deviations below the mean. Skew typically ranges from 100-150, with 100 suggesting returns are normal, but as the skew rises above 100 the probability of outlier returns start to increase.
As you can see in chart 1 below, the 50-day moving average of the S&P 500 skew index has been rising since July, and is currently at 137, suggesting that the chance of outlier returns has increased in recent months. So, options traders are buying out-of-the-money options in case the S&P 500 falls off a cliff, and they are doing so at an ever faster pace. In contrast, the Vix index is at extremely low levels, which is one reason why the S&P 500 is continuing to push higher and make frequent record daily closes.
Why market protection strategies could trigger a sell off
The best way to explain this divergence is that even though traders are willing to push US indices higher, they are getting more nervous and less confident that the rally will last. The skew index rose sharply between January and May this year before pulling back between May and July. Interestingly, since the summer months, investor nervousness has once again started to rise. This rush for downside protection has coincided with the Fed shrinking its balance sheet and higher levels of political dysfunction in Washington, however, these events have not been enough on their own to trigger a sell off.
The next few weeks may be crucial, if the CBOE skew index gets above the 139 high from May and heads towards 150 then this would suggest even more heightened levels of investor nervousness, which could trigger some large scale selling. Thus, the much anticipated decline in the S&P 500 and other US indices may not come from a single black swan event like it did in 2008, but instead from a collective market nervousness that stems from the high levels of accumulation of downside protection against a fall in the S&P 500. Thus, at this stage of the market rally, excessive hedging may be one way of determining when the market will take a turn to the downside.
VIX Index and SKEW Index
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