- SPX downside skew is steep but not necessarily due to crash concerns
* S&P 500 skew (3M 90-100%) has steepened to near multi-year highs (Figure 1, left) even as upside skew remains muted. This is among the highest level of downside skew seen at this level of ATM implied volatility since Sep-02 (Figure 1, right). While is it tempting to point to the elevated skew as a flashing warning sign for the equity market, we believe it is more representative of tightened risk management controls than investor fear of an imminent crash.
* Single-stock skew hasn’t risen: Weighted average downside (and upside) skew for SPX components is near decade lows (Figure 2). Also, a large number of SPX top 50 members have skew below their 30-th percentile over the past year (Figure 3). We find ourselves hard pressed to explain these observations were there a heightened fear of a strong market decline.
* Skew may be driven by dealer activity: Given geopolitical concerns and with US equities near highs, dealers would rather (or are forced to) have some tail protection on the books given risk limits (Figure 4). A downside vol supply/demand imbalance may exist with vol sellers waiting for higher levels to sell while dealer demand for book hedges continues.
* Put activity muted: OTM listed put volume, although an incomplete measure (reported volume doesn’t indicate direction), is up only slightly which further points to a lack of widespread fear
* Positioning around high skew: Protection buyers should consider trading put spreads rather than outright puts – it’s the downside tail that is expensive to hedge right now. High skew also cheapens down-and-out puts which can be an effective way to position for a moderate decline.