Skew Index

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21 Aug, 2024

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The Skew Index, often called the Black Swan Index, measures potential tail risk or extreme events in financial markets. A high value indicates an increased likelihood of the risk of adverse events taking place in a given period, which enables investors to gauge and prepare for unforeseen market shocks.

It is crucial for investors as it quantifies the likelihood of extreme market events, such as crashes or spikes. By monitoring this index, investors can assess the potential tail risks in their portfolios and implement risk management strategies to mitigate the impact of unforeseen market shocks.

What Is The Skew Index?

Skew Index measures potential tail risk in financial markets by analyzing the prices of out-of-the-money options, particularly focusing on the likelihood of extreme market events and corresponding movements.
While it measures tail risk in markets, flagging adverse market movements to enable investors to take action, the Cboe Volatility Index (VIX) estimates expected volatility over a 30-day window. The VIX reflects short-term market uncertainty. Both offer insights into risk and sentiment, supporting investor planning and decision-making.
It assesses tail risk, facilitates portfolio protection, and serves as an early warning system. However, due to its limited scope, it may not be able to capture the effects in real-time. Hence, adverse events may not be factored in immediately while making decisions. Also, interpreting this index may be challenging for some.

Skew Index Explained

The Skew Index, also called the Chicago Board Options Exchange or Cboe Skew Index, is a measure designed to gauge potential tail risk or the probability of extreme market events, often referred to as black swan events. It is calculated based on the prices of the out-of-the-money Standard & Poor's 500 (S&P 500) options, particularly focusing on the prices of the out-of-the-money put options.

Put options provide holders with the right but not the obligation to sell an asset at a predetermined price within a specified timeframe. The index typically rises when the demand for out-of-the-money put options increases, indicating that investors are increasingly hedging against potential downside risks in the market.

Unlike other volatility measures like the Cboe Volatility Index (VIX), which focuses on near-term volatility expectations, the skew index focuses on the perceived risk of large negative movements in the market. A higher index value suggests that investors are willing to pay higher premiums for out-of-the-money put options, reflecting a heightened expectation of severe market downturns.

It serves as a valuable tool for investors and risk managers, providing insights into the market sentiment regarding potential tail risks and helping them adjust their portfolios and risk management strategies accordingly to prepare for such events. It is important to understand and acknowledge its importance without discounting the fact that it is only a prediction mechanism, which means it cannot read market movements with full accuracy. It means the likelihood of the event and its risk are high, but the event may or may not occur despite the high numbers.

Examples

The index shows investor sentiment. However, it may not always correctly predict market crashes. In this section, let us study some examples to understand the concept.

Example #1

Imagine an investor, Sarah, who is concerned about a possible market crash. To protect her portfolio, Sarah decides to purchase out-of-the-money put options on the S&P 500 index. These put options would allow her to sell her stocks at a predetermined price if the market were to experience a significant downturn.

As geopolitical tensions escalate, Sarah observes an increase in demand for these out-of-the-money put options among other investors who share her concerns. Consequently, the prices of these options rise significantly. This rise in option prices is reflected in the Skew Index, which measures the perceived risk of extreme negative moves in the market.

In this example, the surge in the Skew Index indicates that investors like Sarah are increasingly willing to pay higher premiums to protect against potential market crashes. It serves as a warning sign of heightened fear and anticipation of adverse market events, prompting investors to take precautionary measures to safeguard their portfolios.

Example #2

A February 2016 article stated that the cost of protection from black swan events, which are already considered challenging, increased more than ever as the CBOE Skew Index reached an unprecedented high in that period.

This index by the Chicago Board Options Exchange measures the perceived risk of serious downturns in US equity markets, keeping tail risk beyond usual fluctuation levels (two to three standard deviations below the mean) in view. The elevated skew values indicated heightened investor fear of a black swan event, with readings between 115 and 135 signifying increased risk.

Factors contributing to the surge in skew at the time included weak economic growth in China, speculation over Federal Reserve interest rate hikes, and geopolitical concerns. Not all traders were anxious due to the rise in this index. Nevertheless, the surge in the index caused a certain level of anxiety in the market, with past instances of a rising index preceding events like the Flash Crash in 2010. Traders believed that it made sense to pay a premium for security.

Advantages And Disadvantages

Though this is an important indicator of market movements and the overall direction the US economy might take in a given period, investors and traders must understand the pros and cons of applying it. The advantages and disadvantages of this index are listed below.

Advantages

Tail Risk Assessment: This index provides a valuable measure for assessing tail risk in financial markets, helping investors gauge the likelihood of extreme negative movements.
Early Warning System: An increase in the skew index can serve as an early warning signal for potential market shocks, allowing investors to adjust their portfolios and risk management strategies accordingly.
Portfolio Protection: By monitoring this index, investors can implement hedging strategies and allocate resources to defensive assets to protect their portfolios against unforeseen market downturns.

Disadvantages

Limited Scope: The Skew Index focuses primarily on tail risk in equity markets, potentially overlooking risks in other asset classes or economic factors that could impact overall market stability.
Volatility vs. Tail Risk: While it measures tail risk, it may not provide a comprehensive assessment of overall market volatility, which could lead to a skewed perception of market conditions.
Lagging Indicator: The Skew Index may not always provide timely signals of impending market events, as it relies on options pricing data and may lag behind real-time market developments.
Problems with Interpretation: Not all investors may be able to interpret and act according to the input given by this index, resulting in missed signals or opportunities.

Skew Index vs VIX

The skew index and CBOE Volatility Index (VIX) are closely related and can be studied in conjunction when making trading or investment decisions, but they are not the same. Here are the differences between them.

Points	Skew Index	VIX
Definition	It measures the perceived risk of extreme negative moves in equity markets, specifically focusing on tail risk beyond two to three standard deviations below the mean.	Cboe Volatility Index (VIX) measures the expected volatility of the S&P 500 index over the next 30 days, reflecting investors' expectations of near-term market volatility.
Protection type	It provides insights into the likelihood of extreme events or black swan occurrences, helping investors assess the potential for significant market downturns.	It reflects market sentiment and expectations regarding short-term volatility, indicating the level of uncertainty or fear among investors.
Protection goals	Investors buy put options for protection when the index rises to hedge their positions against possible lows or downturns.	Traders interested in managing short-term market movements follow this index to make portfolio strategizing and management adjustments.
Focus	It reflects investor sentiment.	It reflects market uncertainty.

Frequently Asked Questions (FAQs)

How is the skew index calculated?

The skew index is calculated using the prices of out-of-the-money options, primarily focusing on out-of-the-money put options on the Standard & Poor's 500 (S&P 500) index. These options' prices are analyzed to determine the perceived risk of extreme negative market movements beyond standard deviations from the mean.

Is the skew factor related to the skew index?

The skew factor, also called skewness, is a statistical measure that quantifies the asymmetry of a probability distribution. In financial markets, skewness can indicate the degree of asymmetry in returns, particularly whether the distribution has a longer tail on one side, potentially signaling higher risk. The two terms are related in terms of their application but represent different concepts, where the index considers the overall skewness across the market.

Why is the skew index important?

It is important because it provides insights into potential tail risk or extreme market events, often referred to as “black swan” events. By gauging investors' perceptions of such risks, this index helps inform risk management strategies and portfolio adjustments to mitigate the impact of unforeseen market shocks.