Forget The VIX: SKEW Tells The True Story About Hedging Market Risk

Tyler Durden's picture

Once again retail is getting duped into believing that all is well in the market by daily blasts of just how low the VIX has plunged. And it has: it is down to levels not seen in years. But as everyone who has done even a little work in option vol, the only index that matters these days, at least for equities now that precious metals and certain currencies (CHF) are the true flight to safety, is the SKEW. As we have disclosed many times in the past, SKEW is how the pros play vol, while VIX is what is left for the peasantry and CNBC. Basically, VIX shows riskiness as implied by ATM options, while SKEW demonstrates the difference between ATM and OTM options. And as the chart below shows, there is a rather dramatic difference when looking between the VIX and SKEW indices. In essence what is happening is that everyone is selling ATM short-dated vol and buying mid-term Out of the Money vol as expressed by the SKEW, in a confirmation that the protection cost in the wings is actually much higher than one would assume.

For those still confused, this is how it was described previously:

The chart below shows this quite clearly as VIX (At-the-money vol) ebbs away (red arrows) as the day-to-day vol of more 'normal' mark-to-market movements is culled thanks to the liquidity fueled effervescence, the rise in out of the money (or crisis/event risk) vol has risen dramatically (white arrows). This can only go on so long as vol arbitrageurs will creep up the moneyness curve (to hedge the tail risk) and eventually impact the ATM. This happened in early 2010 and is happening again currently.

The recent moves in the major credit indices also fits with this world view as any smarter-than-the-average bear capital structure arbitrageur knows that the skew (and specifically the out of the money vol market) has a much better relationship with credit than the near-the-money. One other potential way to think of this (hattip to Artemis recent article on this) is that the skew better represents the real market value of the Bernanke Put (i.e. how much is the market pricing in the never-ending story of a Fed-provided safety net) - perhaps notable that the SKEW began to rise very shortly after Jackson Hole and the QE2 plan came online.

Needless to say, the SKEW does not paint a remotely as rosy picture as does the VIX.

Lastly, another index you will never hear about is the Credit Suisse Fear Barometer, presented on the chart below.In a nutshell: "The CS Fear Barometer measures investor sentiment for 3-month investment horizons by pricing a zero-cost collar.  The collar is implemented by the selling of a 10% OTM SPX call option and using the proceeds to buy an OTM put.  The CSFB level represents how far out-of-the-money that SPX put is.  The higher the level, the greater the fear."

Paints quite a different picture than the VIX doesn't it?