I wrote about the CBOE Skew Index a couple of months ago and talked about how it had become a fantastic predictor of correction market moves in 2014.
To review, the skew index is a compilation of bets placed on out of the money options, mostly puts. These bets are looking for a big move south very quickly, perhaps the result of some sort of “black swan” event. For the most part, these risky bets rarely pay 0ff – 5% of the time or less.
When the bets do pay off, the gains are sharp and quick. Many option players buy these options as protection or a hedge against an overbought market condition. Well, we are bumping up against an overbought condition that may produce another sharp correction – soon. See the skew index below.
What I have found interesting in 2014 is that when the skew index spiked (more bets on the spikes increases the price of the index), there has been a healthy correction every time. The last big high in skew was in mid-September, and what unfolded afterwards was a 9.4% correction. All others this year were swift but mild, about 4-6% in size and no more than two weeks in duration. More recently the skew hit near 138, and a 5% correction ensued.
However, correction calls with a high skew generally are coupled with a low volatility index (VIX). In just about every case in 2014, the VIX was 13% or lower when skew was high – in one case, it was close to 10%. That is a reading of high complacency and no buyers. When the buying is done, there is nothing left to do but sell. The smart money will reach for protection when it’s cheap (as it is when the VIX is low) to guard against losses on their long stock/option plays.
It is hard to understand this counter-play being successful. Buying a 5% probability expecting a payoff is a very poor bet, but the point is buying insurance BEFORE something disastrous occurs. Further, the hope is that this protection does not pay off, but it’s good to have just in case. If you do not have fire insurance on your house and all of a sudden your neighbor’s roof is in flames, you’re not on the phone with your insurance agent looking for coverage, right?
In addition, the MC oscillators have clocked in now over 100 on both the NYSE and Nasdaq, as breadth has been strong over the last several days (Dow Industrials are up for 7 days straight). That is not yet an extreme overbought condition, but it is headed there.
So, we are currently at 135 on the skew index, not the highest level of the year, and we have a VIX at 14.5% – also not the lowest reading. As the holiday trading continues, we should see volatility drop even more, and as that happens, we’ll see the smart money reaching for cheap protection. Not a bad idea for us to do, either. I’ll be watching both of these closely.