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.
VIX is the CBOE’s “Market Volatility Index”. It pre-dates SKEW, and “translates, roughly, to the expected movement in the S&P 500 index over the next 30-day period”. As far as I can tell, VIX presupposes that the probability distribution of future S&P 500 returns is normal, i.e. that higher-than-expected returns are as likely to occur as lower-than-expected returns at the same distance from the mean. That this assumption need not be made is what lies behind the divergent VIX and SKEW movements discussed in the ZH post.
The phrase “out-of-the-money options vols” requires some unpacking. To begin with, an option is a contract which grants the buyer certain rights. A put option grants the buyer the right to sell an asset at a set price (the strike price) on or before some date. A call option grants the buyer the right to buy an asset at a set price on or before some date. Loosely speaking, the buyer of a put is betting that the underlying asset will fall in value, and the buyer of a call is better that it will rise.
Option prices depend on a lot of things, but the important one here is expected volatility, loosely defined as the perceived unpredictability of the underlying asset’s price over the term of the option. The greater this perceived unpredictability, the risker the option appears to be to sell, and therefore the higher its price. This means that given an option’s price (and some other information), one can back-compute the perceived volatility that was baked into its price; this is called the implied volatility of the underlying asset.
Options can be “in the money”, “at the money”, or “out of the money”, depending on the relationship between their strike price and the current market price of their underlying asset. An option with a strike price equal to the asset’s current price is “at the money”, while an option with a strike price “better” than the the asset’s current price is “in the money”. (An “in the money” put has a strike price above the current price, while an “in the money” call has a strike price below the current price.) Otherwise, the option is “out of the money”.
From all this, we can say that “out-of-the-money options vols” refers to implied volatilities of the S&P 500 computed from the prices of out of the money options on that index. (“Vols” is plural because, as we’ll see in a bit, options with different strike prices can carry different implied volatilities.)
When the author writes that “the cost of protecting against a much more serious drop (or tail event) has increased quite notably” what he means is that the prices of far out of the money puts have been increasing. If you own an asset, and you want to protect yourself against a fall in its value, you buy put options. If you want to protect yourself against even a small loss, you buy at the money options, while if you’re willing to lose a little, but not a lot of money, you buy options that are slightly out of the money — options with strike prices slightly below the current price. If you’re willing to take largish, but not unlimited losses, you buy options with strike prices far below the current market price; such options tend to be quite cheap, because their expected value is quite low. The “cost” referred to by the author is the price of purchasing these options; the fact that their prices are rising means that that the implied volatilities that they carry are increasing as well.
This is all relevant because it turns out that the volatilities implied by the options on an asset differ depending on whether those options are puts or calls, as well as whether those options are in, out of, or at the money. In fact, it is precisely these differences on which the SKEW index is based.
So, what out jargony friend is saying is that despite the fall in one measure of expected future volatility (the VIX index), other measures (the price — and therefore implied volatility — of out of the money options) are increasing; these other measures are captured by the SKEW index.
Incidentally, I suspect that what he meant to say was not “out of the money options”, but “out of the money puts“, since (a.) a call does you no good when hedging against a drop and (b.) the SKEW index actually measures the degree to which out of the money puts carry a higher implied volatility than equally out of the money calls. Combined with the “as many Pros know” language, pointlessly introducing a “smart insiders agree with me” rhetorical gimmick, the author isn’t making a very good impression.