Washington DC, North Korea Have Skew at Multi-Year Highs
Despite the S&P500 (SPX) being less than 2% off the all-time high it achieved a mere three weeks ago, market signals are suggesting that investors are beginning to turn bearish on equities. Turbulence within the Trump administration, the potential for a government shutdown, and tension with North Korea all have investors nervous as volatility starts to pick up after a historically low period the past several months. As a sign market participants are wary of a pullback in equities, traditional safe-haven assets such as gold and the Japanese Yen have been rallying since mid-July.
This week’s chart is another indication investors are positioning for an equity selloff. Volatility skew in SPX options markets – differences in implied volatility between in-the-money, at-the-money, and out-of-the-money options – is at multi-year highs. This development indicates that the cost of owning SPX put options (which increase in value when the index declines) is very high in relation to owning call options on SPX (which increase in value when the index rises). As an example, for the cost of purchasing one SPX put option expiring in three months and struck at 2300 (6% lower from the current level), you can purchase thirteen SPX call options with the same expiry struck at 2600 (6% higher than the current level).
We have seen skew steepen (puts become more expensive relative to calls) before major events in the past several years. In the lead up to the June 2016 U.K. Brexit vote, November 2016 U.S. Presidential elections, and April 2017 first-round French Presidential elections, skew steepened on all three occasions as investors bought puts to protect against an adverse outcome. Immediately following each event, however, skew reversed and retracted to a lower level than where it had originally begun its run up.
Elevated skew makes selling puts to buy calls an attractive way to gain upside exposure to equities. As we saw with Brexit and the U.S. election, skew can fall (puts cheapen relative to calls) after the event even when the “surprise” outcome occurs. The budget discussions to fund the government past September 30 is another event risk that has skew elevated. Recent turbulence from the Trump administration and North Korea are also adding to the bid for puts.
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