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George Bonne

George Bonne
Executive Director of Equity Factor Research

Fearing black swans, investors eye options

It’s been widely reported that equity-market volatility, outside of a mid-May spike, has been oddly low given investor concerns that range from North Korean saber-rattling to the fate of tax cuts proposed by the Trump Administration. But look beyond the widely followed “fear index” (formally the CBOE Volatility Index, or VIX) and you’ll find that markets remain concerned about a “black swan,” to use a term coined by risk analyst and author Nassim Taleb to describe low-probability but high-impact events.

How do we know this? Because investors are buying downside protection for their portfolios in the form of deep out-of-the money put options.

In a previous post, we examined what lies behind recent low levels of volatility in global markets. We found that three measures of volatility — implied (as measured by the VIX), realized (historical volatility) and forecast volatility (from the MSCI Barra US Total Market Equity Trading Model) — were  consistent with each other and that the average correlation between stocks dropped to historically low levels, which helped drive down total volatility.

Here we explore another measure of risk to see if it paints the same low-risk picture as volatility. This time, we look at a measure of perceived “tail risk” — the chances of a rare and largely unpredictable adverse event — based on “options skew.” If the skew — the difference in implied volatility between an out-of-the-money option (OTM) and an at-the-money (ATM) option1  – is high or rising, that suggests that investors are increasingly concerned about the likelihood of an extreme negative market event. As fears of tail risk rise, the price of insurance against those events (reflected in the implied volatilities of OTM puts) rises while the price of OTM calls declines. Thus, options skew may reflect fear that is not revealed in VIX levels.

In the exhibit below, we display average implied volatility curves of S&P 500 options from 1996 to May 18, 2017. We see that, on average, as we go further out-of-the-money, put options become more expensive while call options become less expensive. By our definition, call options on the S&P 500 generally exhibited negative skew while puts had positive skew.. We define our skew metric as the sum of the put and call skews.

The cost of protecting against extreme events

Average implied volatility curves for OTM SPX options (30 days to expiration, 1996 - May 18, 2017). Puts become more expensive while calls become less expensive as we go farther out of the money.


Below, we show the relationship between our measure of skew and VIX, highlighting points since 2010 and during April and the first half of May 2017. The overall relationship is quite strong (R2 of 0.67). However, both recently and since the financial crisis most of the points lie above the best-fit line, indicating that skew has been high for the given level of VIX. Thus far in 2017, the “excess skew” as measured by the distance above the best fit line, peaked at the end of April, just before the first round of the French presidential election, and again during the spike in VIX on May 17. It has remained at elevated levels during the historically low volatility observed in May.


Options skew remains elevated in 2017


Prior to the financial crisis, most points lie below the best fit line; after the crisis, most of the points lie above the line, indicating generally greater concern for potential tail events. By examining options skew, we can gauge the market’s fear of extreme events — revealing market anxiety that may not be reflected in VIX. Since the financial crisis, expectations of potential market shocks have increased, and persist even in the current low-volatility environment. Market participants appear to be signaling that it is indeed quiet, too quiet.

1 We use standardized and interpolated implied volatility curves as a function of delta to define our skew measure. We use delta values of 50% and 20% (-50% and -20%) to define our at-the-money and out-of-the-money points for calls (puts), respectively.

The author thanks Dimitris Melas and Peter Zangari for their contributions to this post.


Further reading:

Why is “fear” missing from the “fear index”?

Which factors are more time-sensitive?

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