For A Different Look At Volatility, Look To The SKEW

by: Elusive Value


The VIX is still near historical lows while the SKEW is near the high end of its range.

Recently high-profile analysis by Oaktree's Howard Marks and JPMorgan's Marko Kolanovic may have awakened the VIX and its lesser known sibling, the SKEW index.

However, better than expected Q2 earnings results may keep VIX low and the bull market extending further.

Is there a correlation between the VIX and SKEW, and can it predict a market correction?

We'll look at some trades to capitalize on a volatility spike as VIX's high season arrives.

As a value investor, I have been taking profits over the past couple of years, waiting for a significant correction to do some bargain hunting. With the exception of some stocks making new 52-week lows, the overall market has not provided the type of "blood in the streets" panic selling I have been anxiously waiting. But I also enjoy special situations, and the recent trend of extreme low volatility prompted me to do a little trading while waiting for Godot, as it were.

With the Trump reflation idea seeming less and less likely since the start of the year, it makes little logical sense that volatility hasn't returned to pre-2017 levels. In fact, most of the lowest closes in the VIX since 1993 have occurred just within the past two months! Most everyone has heard of the VIX, CBOE's popular "fear" indicator of the S&P 500 index. Fewer have heard of its sibling, the SKEW index.

Let’s take a quick look at what the VIX and SKEW values represent. Both the VIX and SKEW values are calculations based on implied volatility (IV) of S&P 500 options expiring roughly around 30 days in the future. The primary difference is that the VIX is based upon IV around the At-The-Money (ATM) strike price, while the SKEW looks at IV of Out-of-the-Money (OTM) strikes. Additionally, the way the SKEW is calculated, the normal range of the SKEW is somewhere between 100-150.

You can see easily see this "skew" in the chart below. If the SKEW were closer to 100, the line would more resemble a slight smile. The IV of OTM puts for the August 31 2017 expiration implies that traders are hedging more than normal on a black swan event.

SKEW of Aug 31 2017 put (source: Author. Data from TD Ameritrade $SPX option chain)

In the past few weeks, something of a divergence has occurred between CBOE's SKEW and VIX indexes. With the VIX closing closing at 10.09 as of 8/1/17, the CBOE SKEW number was close to 140. In the chart below, notice how the VIX and SKEW appear to be fairly correlated and/or moving in the same direction, most of the time. However, in the last month, the VIX has gone lower while SKEW has trended higher. - $VIX vs. $SKEW (source: $VIX, $SKEW)

More analysis is needed to see if there truly is any correlation to market corrections. Since traders are simply showing more interest in OTM puts as protection, but are not exiting long positions en masse, this divergence doesn't appear to forecast a correction.

However, it also doesn't make sense for SKEW and other volatility measures (like less popular calculations for Nasdaq and Russell vol) to remain relatively high while the VIX stays extremely low - it should mean revert. There are several catalysts for the VIX to spike and return to a normal range. Several recent articles point to the August-October period as being seasonally volatile. Take a look at the following chart. The x-axis represents January through December months. The red line is the average VIX for the last 5 years, while the blue is the 2017 VIX to-date. If history is any indication, the VIX should really start to move near the end of August.

VIX seasonality - 5y average (source: thinkorswim YTD vs. 5y seasonality chart of $VIX)

Next we have the same chart, but showing the 20-year VIX average. This really illustrates just how low the VIX has come down compared to historical norms. I think most would agree when comparing the 5-year and 20-year VIX averages, that easy money from central banks have really squashed volatility. Even so, it's clear that September-October are on average, more volatile than the other months of the year.

VIX seasonality - 20y (source: thinkorswim YTD vs. 20y seasonality chart of $VIX)

Other catalysts for a higher VIX include geopolitical risks, as well as increased uncertainty and lack of progress in Washington. Another signal is the recent weakness in the Dow Transportation average vs. the neck-snapping record highs of the Dow Jones Industrial index. Further, the Fed has announced several times that they will begin reducing the balance sheet this year, yet the market has not reacted accordingly.

With all of these headwinds, bulls have cited favorable earnings and economic data as reasons the market will continue to rise. More to the point, some have provided analysis that S&P returns trend positive for several months following extreme low volatility.

I recall laughing at pundit headlines following the Great Recession proclaiming that the Dow was on its way to 20,000 - we're just about at 22,000. Apple (AAPL) was a hated stock a couple years ago, so much so that it was a fixture on Joel Greenblatt's Magic Formula screen. As I write this, Apple is up to a new 52-week high of $159 after-hours, following a glowing earnings report, which would put it past a staggering $800B market cap. With that kind of outsized weighting in the S&P, we may be seeing new all-time lows in the VIX over the next few days.

So a low VIX does not necessarily portend that a market correction is imminent. However, the high reading of the SKEW does imply that traders are hedging against a black swan event. In such an event, the VIX will necessarily spike as IV goes up across the board.

Correction or no correction, with August-October seasonality coming up, here are some a couple of ideas for capitalizing on a volatility spike. When VIX makes or nears recent lows, you can buy near-term OTM calls in $VIX futures, or long volatility ETF/ETNs (iPath S&P 500 VIX Short-Term Futures ETN (NYSEARCA:VXX), ProShares Ultra VIX Short-Term Futures ETF (NYSEARCA:UVXY), ProShares VIX Short-Term Futures ETF (NYSEARCA:VIXY), VelocityShares Daily 2x VIX Short-Term ETN (NASDAQ:TVIX)) with an eye to hold for a very short duration to avoid daily rebalancing losses. Keep in mind that trading in some of these names will generate the dreaded Schedule K-1 that may impact or delay tax return filing for U.S. investors. I also don't like holding long vol ETFs because it is emotionally difficult to sell at a loss when logically the VIX should be going higher.

If you're long equities, the simple and smart trade is to buy protection when it's dirt cheap. You can buy a long put on $SPX or SPY for a strike at or near the money for very low premium.

For a higher risk-reward trade, you can buy very short-term OTM calls on long vol ETFs. These are extremely volatile and will likely expire worthless. To help offset the theta on those calls, I've been employing a synthetic long strategy on long vol ETFs that help offset the premium paid for the calls. Here's how this works. We know that long volatility ETFs suffer from near daily losses due to having to rebalance the front and second month VIX futures, which are usually in contango. But those losses are somewhat predictable given small daily changes to the VIX. Knowing this, you can sell puts and use some or all of the credit to buy long ATM or OTM calls. Here's a conservative example using VXX, which is trading around $11 as of 8/1/17:

  • Sell a VXX Aug 11 2017 $11 put for $0.30
  • Buy a VXX Aug 11 2017 $11.50 call for $0.20, or two $12.00 calls for $0.15 each
  • This would result in a roughly free trade, with the risk of being forced to buy VXX at $11.

For a higher risk-reward, you can trade a similar synthetic long in UVXY, which is a leveraged 2X long vol ETF. To illustrate, I was long UVXY OTM calls with a Jul 28 2017 expiration. When Kolanovic came out with his comments on 7/27/17, the VIX shot up and I saw my UVXY calls flip ITM and go up over +220% intra-day. However, that spike was short-lived as HFTs or volatility shorts quickly drove the VIX back down, leaving my calls worthless the following day.

Again, these are very volatile trades and the standard option disclaimer applies. Due to the decline in the VIX this year, these trades have not been profitable as a whole. Also, to stay in the game, you need to monitor daily and roll them over to the next expiration. When VIX spikes, you may want to take your profits quickly to avoid risking the calls expiring worthless.

Disclosure: I am/we are long TVIX.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am also long VXX CALLS, short VXX PUTS, short SVXY LEAP CALLS.