If Everything's So Awesome, Why Are Investors Paying So Much For Crash Protection?
Tech stocks soaring to record highs and a slump in volatility suggest investors are brushing aside market risks, trade war concerns, and Central Bank tightening.
However, as Bloomberg notes, there is at least one gauge of investor sentiment that hints at a growing concern. The Cboe Skew Index, which tracks the cost of tail-risk equity protection, has jumped to the highest level since October. The rise signals options traders are growing wary of wild swings, just as the International Monetary Fund warned financial markets seem complacent to mounting risks in the global economy.
Generally, a rise in skew indicates that 'crash protection' is in demand among institutional investors (institutional/professional investors are the biggest traders in SPX options).
But an unusual move in the skew index (which historically has tended to oscillate approximately between a value of 100 and 150) is especially interesting when it diverges strongly from the VIX, which measures at the money and close to the money front month SPX option premiums.
Basically what a 'low VIX/high skew' combination is saying is: 'the market overall is complacent, but big investors perceive far more tail risk than usually' (it is exactly the other way around when the VIX is high and SKEW is low). Below is a chart showing the current SKEW/VIX combination...back to the same level it was at before the short-vol collapse accelerated in Jan/Feb.
In other words, a surprising increase in realized volatility may not be too far away.
Perhaps this is one reason why - based on the uncertainty of economic policy, VIX should be trading north of 40...
But it's not just equity crash risk that is bid, credit investors are piling into CDS markets, worried there won’t be enough liquidity in a downturn - taking steps to avoid getting stuck with hard-to-trade corporate bonds.
As Bloomberg reports, volume on Markit's CDX North American Investment Grade Index, which tracks default swaps on 125 high-grade corporate bonds, reached a new milestone in the first half of 2018 of $1.56 trillion. That eclipsed every previous period in the past five years of data available.
An abrupt surge in turnover in such derivatives typically coincides with periods of turmoil as investors rush to hedge credit risk.