Zero Hedge (ZH) is an interesting site. You see it linked pretty frequently around the blogosphere, and it seems like there’s something meaningful being said there. Now, I have a weak spot for Fight Club references, and whole-heartedly endorse the sentiment behind ZH’s slogan: “On a long enough timeline the survival rate for everyone drops to zero.” But …
There’s a problem with ZH: I have no idea what many of the sentences written there actually mean. (Since I majored in economics, I’m not sure that this is entirely my fault; I suspect the ZH writers make an effort to be cryptic as a point of style.) I get the gist of what they’re driving at, but not the detail. Today I’m going to begin a careful examination of one of their pieces, with an eye to seeing what, if anything, it actually means. (I had originally intended to do this all in one post, but found that its length quickly grew out of control.)
Here’s the original piece:
CBOEs recent introduction of the SKEW Index brings the realities of the options market (and real fear indexes) to retail investor’s eyes. With so much attention paid to the VIX (the anachronsitic FEAR index) and especially its dropping over the last few months, investors are led to believe that risk is reducing but lo and behold, as many Pros know, the cost of protecting against a much more serious drop (or tail event) has increased quite notably with out-of-the-money options vols rising notably. 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.
There are also charts. ZH loves charts.
Parsing the Opening Sentence
CBOEs recent introduction of the SKEW Index brings the realities of the options market (and real fear indexes) to retail investor’s eyes.
CBOE is the Chicago Board Options Exchange. It is a business which makes its money by facilitating the trading of derivative contracts (such as options).
The SKEW index is:
[A]n option-based indicator that measures the perceived tail risk of the distribution of S&P 500® log returns at a 30-day horizon. Tail risk is the risk associated with an increase in the probability of outlier returns, returns two or more standard deviations below the mean. Think stock market crash, or black swan.
The most important word here is “perceived”. The SKEW index does not measure risk; it measures (or purports to measure) the aggregate perception of risk of all market participants.
“Log returns” just means that rates of return are calculated as if they were continuously compounded. This is a formalism that doesn’t really affect the interpretation of the overall ZH item.
Therefore, we can say that SKEW is a number that is calculated from option prices (you can read about the details of the calculation here) and intended to measure the risk of really bad S&P 500 performance over the next 30 days, under the assumption that the market’s overall assessment of that risk is accurate.
Returning to the ZH sentence: A “fear index” is any number that purports to measure the overall expectation of market participants of near-term volatility, and a “retail investor” is the average sucker. We can now unpack the entire first sentence, which simply says that the introduction of a new measurement of market expectations of the risk of unusually bad returns brings the “reality” of such measurements of risk to the average sucker.
This is not an auspicious beginning. Anytime anyone starts talking about “the reality” of something, it’s almost always a sign that snake oil futures are on the rise.
On Monday, we’ll resume this project with the exciting second sentence, which introduces the VIX index and implied volatilities!