In a December 8 Bloomberg news report – “Who’s the Bear Driving Up the Price of U.S. Stock Options?” – Joseph Ciolli wrote – “For more than a year, dealers in the U.S. equity derivatives market have noted a widening gap in the price of certain options. If you want to buy a put to protect against losses in the Standard & Poor’s 500 Index, often you’ll pay twice as much as you would for a bullish call betting on gains. New research suggests the divergence is a consequence of financial institutions hoarding insurance against declines in stocks.”
CBOE SKEW INDEX
The levels of the CBOE SKEW Index indicate increased demand for out-of-the-money (O-T-M) SPX puts during the past couple of years. The average daily closing levels of the CBOE SKEW Index have been —
(a) 118.0 since its start date in January 1990,
(b) 129.8 in 2014 (the all-time high for any year), and
(c) 126.9 in 2015 (through Dec. 8).
The value of the SKEW Index increases with the tail risk of S&P 500 returns. If there were no tail risk expectations, SKEW would be equal to 100. Historically, SKEW has varied in a range of 100 to 150 around an average value of 118. The FAQ on the SKEW Index notes that – “The price of S&P 500 skewness is inconvenient to use directly as an index because it is typically a small negative number, for example -.8, -2.3, or -4.3. SKEW converts this price as follows: SKEW = 100 – 10 * price of skewness. With this definition, a price of -2.1 translates to a SKEW value of 121. S&P 500 options with 30 days to expiration are generally unavailable. SKEW is therefore interpolated from two “SKEW” values at the maturities of nearby and second nearby options with at least 8 days left to expiration.” www.cboe.com/SKEW.
VOLATILITY SKEW FOR SPX OPTIONS
The volatility skew charts below show that Bloomberg’s estimates for SPX 30-day implied volatility on recent dates were quite a bit higher for SPX options at 80% and 90% moneyness when compared with SPX options with moneyness at 100 or higher. Reports have indicated that O-T-M SPX put options usually have had higher implied volatilities than at-the-money SPX options and O-T-M SPX call options since 1987.
At his comprehensive December 1 presentation at the First Annual CBOE Risk Management Conference (RMC) Asia in Hong Kong, Buzz Gregory of Goldman Sachs discussed skew –
- (1) The skew for the S&P 500 is the highest of any major market in the world, and
- (2) The S&P 500 skew may remain high because of regulatory pressure on big banks to hedge big downside risks. Regulatory initiatives include – (a) Comprehensive Capital Analysis Review (CCAR), an annual exercise by the Federal Reserve to assess whether the largest bank holding companies operating in the United States have sufficient capital to continue operations throughout times of economic and financial stress, (b) Dodd-Frank Act stress testing is a forward-looking component conducted by the Federal Reserve and financial companies supervised by the Federal Reserve to help assess whether institutions have sufficient capital to absorb losses and support operations during adverse economic conditions.
DEUTSCHE BANK ON HIGHER SKEW
In his December 8 Bloomberg news report, Joseph Ciolli wrote about the possible reasons for the higher S&P 500 skew levels —
“… While various explanations exist including simply nervousness following a six-year bull market, Deutsche Bank AG says in a Dec. 6 research report that the likeliest explanation may be that demand is being created for downside protection among banks that are subject to stress test evaluations by federal regulators. In short, financial institutions are either hoarding puts or leaving places for them in their models should markets turn turbulent. ‘Since so many banking institutions are facing these stress tests, the types of protection that help banks do well in these scenarios obtain extra value,’ said Rocky Fishman, an equity derivatives strategist at Deutsche Bank. ‘The way the marketplace has compensated for that is by driving up S&P skew.’”
POSSIBLE INVESTMENT IDEAS RELATED TO HIGHER SPX SKEW LEVELS
If you expect that the SPX skew levels will be relatively high in upcoming months or years, what are some options strategies that an investor might consider? One of the most straightforward strategies to consider would be the sale of O-T-M cash-secured SPX put options.
On the writing of SPX put options, the website www.cboe.com/benchmarks has links to a number of papers on and these two benchmark indexes that write cash-secured SPX puts that are only slightly out-of-the-money – CBOE S&P 500 PutWrite Index (PUT) and CBOE S&P 500 One-Week PutWrite Index (WPUT).
Some mutual funds now are engaging in the sale of cash-secured puts; for a listing of more than funds that engage in a variety of options strategies, please visit www.cboe.com/funds for a 2015 paper on “Performance Analysis of Options-Based Equity Mutual Funds, CEFs, and ETFs” – Slide Presentation (30-page PDF) and Highlights (4-page PDF). (CBOE does not endorse mutual funds). According to the analysis in the paper, the number of ’40 Act funds that use options rose from 10 in 2000 to 119 in 2014.