I found something rather odd on Tuesday. The implied volatility skew was up 4.5% on the session, a decent move but nothing abnormal. The vix was also up 16% at the close and at one point 25.3% intraday. So on their own nothing abnormal.
But when you consider what each value measures then things become interesting. Very simply stated the vix measures implied volatility for options “at the money.” The skew measures implied volatility for options “out of the money.” Again this is a simplified explanation.
So in basic theory if investors see no risk in the market both the vix and the skew will be low as implied volatility for all options is low. As fear begins to creep in you would first see it in the skew where investors begin buying out of the money options as insurance and or speculation against “tail events.”
Eventually that fear becomes prevalent enough that it moves to “at the money” options causing the vix to rise. At that point the skew would generally fall. So in an oversimplified analysis one could say the skew leads the vix. A rising skew would signal an eventual rise in the vix and vice versa.
What happened on Tuesday though was a sharp rise in the vix as investors began buying at the money options. At the same time though the skew also rose as investors also bought “out of the money” options. Let me further explain this in three charts.
Chart 1 - Current market, notice the rise in the vix (chart is inverted) and the rise in the skew.
Chart 2 – Notice a similar pattern in September 2008.
Chart 3 – Look what came next in Chart 2. The vix went from 35 to 70 in very short order. Also notice how once the vix began rising sharply the skew finally began to decline.
This is not a guarantee jump in the vix but the rise in both volatility measures signals investor fear is far from abating.
Images: Flickr (licence attribution)
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