Extreme Fear in S&P 500 Option Skew

The public often uses the VIX as the standard measure of “fear” in the overall market. I prefer to look at option skew instead. Skew tells the investor how much out-of-the money puts are being bid up versus out-of-the money calls. If an investor is scared about downside, then he buys puts. If an investor thinks there is room for upside, then he is willing to buy calls. When the difference between the implied volatility of OTM puts dwarves OTM calls, then investors are fleeing for the exits. On May 20, 2010, the skew of 3-month options hit a five year high.

Three month option skew spiked to five year highs on May 20th

Depending upon valuations and underlying market conditions, the skew can signal either prescient fear or undue panic. It seemed that the shuttering of the subprime lender Ameriquest in May 2006 elevated skew quickly even though the market had many more months of rallying. In retrospect, this can be considered the thoughtful re-pricing of downside tail risk. Likewise, the last spike in November of 2007 served as an excellent timing signal to get out of the market.

On the positive side, a spiking skew in November of 2008 and January of 2009 showed more of the panic selling rather than a signal of significant downside to come. In many of these “fear” spikes in skew, the actual spike preceded the local market bottom by a week or more. If the spike on May 20th is a positive signal, then we should soon find our own local bottom.

As a strategy, if you believe we are close to a bottom, selling OTM puts and buying OTM calls looks very attractive with a steep skew. Always think about selling insurance when the building is on fire rather than buying insurance after the major damage has already taken place.