Exposing Ideas to the Envelope of Serendipity

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Friday, December 21, 2012

VIX FUTURES: The Harbinger of Plan B Failure

By the end of yesterday's trading session, the SKEW index revealed that risk of a sharp decline had doubled. Subsequently, Republican leaders announced the postponement of their so called "Plan B" for a House vote last evening. I've mentioned the SKEW index before, but as a quick reminder, here is the CBOE's definition:
The crash of October 1987 sensitized investors to the potential for stock market crashes and forever changed their view of S&P 500® returns. Investors now realize that S&P 500 tail risk - the risk of outlier returns two or more standard deviations below the mean - is significantly greater than under a lognormal distribution. The CBOE SKEW Index ("SKEW") is an index derived from the price of S&P 500 tail risk. Similar to VIX®, the price of S&P 500 tail risk is calculated from the prices of S&P 500 out-of-the-money options. SKEW typically ranges from 100 to 150. A SKEW value of 100 means that the perceived distribution of S&P 500 log-returns is normal, and the probability of outlier returns is therefore negligible. As SKEW rises above 100, the left tail of the S&P 500 distribution acquires more weight, and the probabilities of outlier returns become more significant. One can estimate these probabilities from the value of SKEW. Since an increase in perceived tail risk increases the relative demand for low strike puts, increases in SKEW also correspond to an overall steepening of the curve of implied volatilities, familiar to option traders as the "skew".
Could not help myself from borrowing  from Tim Knight's characterization of the event ... 

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