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Bloomberg Brief: CBOE's New Skew index as a Forward Looking Indicator for the S&P 500

The current level of the CBOE ’s new Skew Index indicates that a sharp decline in the S&P 500 over the near-term has become more likely.

Recent political unrest in the Middle East and North Africa helped lead the Skew index to its highest levels since 2006 on Feb. 18. While the index has retreated from its high, chances of a two- or three-standard-deviation change in the S&P 500 remain elevated.

The CBOE Skew Index attempts to measure tail risks — the probability of a sharp decline of two or more standard deviations on a 30-day log return basis — of the S&P 500. The index is derived from the prices of S&P 500 options, which are also used to calculate the widely quoted VIX index, which tracks volatility.

When the index is equal to 100, there is no perceived tail risk. When the index rises, so does the risk of a sharp decline in the S&P 500. According to the CBOE , the index typically trades between 100 and 150, with an average of about 115.

On Feb. 18, the Skew index reached 136.4, implying a nearly 12 percent risk-adjusted probability of a two-standard-deviation decline in the 30-day log return of the S&P 500. As of Friday, the index fell back to 128.8, which implies a still elevated 10 percent chance of the same decline. At the index’s average of 115, the chance falls to 6.4 percent.

Based on its 2010 predictive abilities, this new index may bear watching. On April 20, it hit a 2010 high of 134.2, just three days before the S&P 500 ended a three-month, 15 percent rally and began a 16 percent decline of similar length.

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