Behind The Market's Furious Reversal: Record High Skew (And Hedges)

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by Tyler Durden
Wednesday, Jul 21, 2021 - 02:25 PM

At the end of June, when the S&P was making new all time highs day after day, and when the VIX was touching fresh 2021 lows, we cautioned that the skew index just hit a new all time high - meaning that put options have been unusually expensive relative to at-the-money options, helping support the put-heavy VIX index. As we further added, high skew, which compares put option prices with at-the-money option prices, has reached new all-time high, and reflected investor perception that high volatility would return should markets sell off.

Commenting on this unusual move, we said that it shows that while on one hand traders seem complacent, they have never been more nervous that even a modest wobble in the market could start a crash. By extension, "they have also never been more protected against a full-blown market crash."

So fast forward to the violent, if brief, air pocket (and hardly a full-blown crash) the market experienced late last week and on Monday, which saw stocks tumble the most in months... only to soar right after. In retrospect, traders have the record high skew to thank for that because while risk reversed sharply on Tuesday and continuing today, traders were fully hedged and ready to pounce.

So following up on his observations from a month ago, when he first noted the record high skew, Goldman's derivatives strategist Rocky Fishman wrote that this week’s volatility pushed equity implied and realized volatility higher, with the VIX briefly hitting 25 during the day on Monday (19-Jul)...

... even if in absolute terms vol is not high: three-week SPX realized vol (12.1%) is still below year-to-date realized vol (13.4%),and Tuesday’s rally brought the VIX back under 20. More importantly, in response to record downside skew correctly implying that a sell-off would bring much higher volatility, skew has now moved even higher - at least for the S&P 500.

Nomura's Charlie McElligott confirms as much, writing this morning that "our desk almost exclusively saw customer monetization of existing Equities downside hedges on Friday and NOT a grab into fresh hedges—because the post GFC muscle-memory is to immediately “sell vol-spike rips / buy the dip in spot,” as the selloffs are just too fast to linger more than a day or two anymore."

He then observes that... that sense, YES, the fast monetization of some of the legacy hedges out there and the return of vol sellers into the more attractive levels to pound / dip buyers in spot was absolutely a contributing part to the powerful rally in spot Equities

Just as we expected would happen one month ago, even if there remains one potential twist:

... separately looking at the continued firm bid to “crash” / downside skew yday, it does seem clear to me that somewhere, some some Market Maker(s) remain short a lot of Puts…which in the case of the Vol smash yesterday (on the Vanna change) likely then meant that they were covering their hedges in Futures shorts on the gappy move higher in index futures

If that wasn't enough, the record high skew also makes McElligott confident that the risk of a crash is distant:

people see 99%ile SPX 6m downside Put Skew while Eq Index makes new all-time highs each and every week, and continue to obsess on the “left tail” scenarios that could see it all fall apart (with NO CARES on “crash UP”)…which further feeds demand for downside crash and then perversely stops out those trying to sell said rich / extreme skew!…and all into fewer natural sellers of tails being left in the market place (both Dealer and Client), after the almost rolling “Vol Shocks” we have experienced over the past 3 year stress lookback period.

Meanwhile, the SPX has not had one-month realized vol as high as the current VIX level (19.7) since November - indicating that options continue to be persistently expensive, which also means that traders are hedging to outsized moves both higher and lower and any selloffs are likely to be fleeting as hedges are cashed in.

That said, given the recent precedent for quick sell-offs to be followed quickly by low volatility, Goldman expects volatility to subside in the near term with more likelihood of a sustained increase in Q4, and a big reason for this is the persistently high index skew.

SPX index skew continues to be at near-record levels, which we see as driven by a lack of downside sellers as much as demand for hedging. The strong reaction of the VIX to Monday’s sell-off, with the VIX up over six points at one point intraday, proved that high skew was justified - at least on a very local level.... on a more persistent sell-off, it would be difficult to sustain the level of implied volatility that skew would indicate.

Meanwhile, from a cross-asset standpoint, Fishman adds that if interest rates staying this low has the potential to be a catalyst for further equity upside (unless they plunge too fast), leaving the potential for near-term asymmetry in SPX potential returns that is the opposite of what option markets are implying.

So how does one trade the persistently sticky record high skew? Goldman continues to like levered risk reversals as a way to take advantage of this dynamic: Sell a 17-Sep 3800-strike put (12.1% OTM) to fund 2x 4550-strike (5.2% OTM) calls for zero net premium. The trade would be subject to dollar-for-dollar losses shouldthe SPX close below the downside strike at expiration.