The Risk of a Crash Has Never Been Higher?

According to the CBOE SKEW Index, the risk of a stock market crash has never been higher.

CBOE SKEW Index graph1

What exactly does that mean?

The SKEW Index is calculated based on S&P 500 options, measuring the perceived tail risk in S&P 500 returns over the next 30 days. The higher the SKEW Index, the higher the implied probability of a left tail or black swan event (click here for a white paper explaining the calculations in detail). At a level of 154, the implied risk of a 2 or 3 standard deviation negative event is higher than it has ever been.

Estimated Risk Adjusted Probability chart2

Source: CBOE

That all sounds incredibly scary, and many a clickbait article would end right here. But as you know by now, I don’t do clickbait very well. We’re here to learn, and learning requires objective analysis.

The key question is not whether the perceived tail risk is high (it appears to be), but whether high perceived tail risk tends to translate into high actual tail risk. To answer that question we need to go to the data.

The SKEW Index dates back to January 1990. If we look at the top 5% of values historically (above 131), what does SKEW tell us about forward returns?

In a word: nothing. On average, the forward S&P 500 returns are not materially different from any random SKEW value.

CBOE SKEW Index vs S&P 500 returns chart3

What’s most interesting, though, is that the SKEW Index has been a very poor predictor of what it’s supposedly anticipating: actual tail risk. To observe that we can compare the worst stock market declines following the highest SKEW levels to the lowest SKEW levels.

As can see in the table below, in every period from 1 day through 12 months, the worst declines following high SKEW levels are actually much lower than the worst declines following low SKEW levels.

CBOE SKEW Index vs S&P 500 returns since 1990 to 2017 chart4

Another way to observe the lack of tail risk predictability in SKEW is to look at the largest 1-day S&P 500 declines. Going back to 1990, none of the worst declines had a SKEW Index in the prior month that was win the top 5% of historical values. So when actual tail risk was present, SKEW did not predict it.

S&P500 largest 1-day declines chart5

That’s not to say that there can’t be a tail risk event in the next day, month or year. There certainly can be, but one should not be expecting an actual tail risk event simply because of high SKEW. Just because option traders are pricing in a black swan event does not mean they will be correct. Which is another way of saying the “market” is not always right. Far from it.


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Related Posts:

Fat Tails and Expecting the Unexpected

The Market is Always Right?

This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.



Charlie Bilello is the Director of Research at Pension Partners, LLC, an investment advisor that manages mutual funds and separate accounts.  He is the co-author of four award-winning research papers on market anomalies and investing. Mr. Bilello is responsible for strategy development, investment research and communicating the firm’s investment themes and portfolio positioning to clients. Prior to joining Pension Partners, he was the Managing Member of Momentum Global Advisors and previously held positions as a Credit, Equity and Hedge Fund Analyst at billion dollar alternative investment firms.

Mr. Bilello holds a J.D. and M.B.A. in Finance and Accounting from Fordham University and a B.A. in Economics from Binghamton University. He is a Chartered Market Technician (CMT) and a Member of the Market Technicians Association. Mr. Bilello also holds the Certified Public Accountant (CPA) certificate.

You can follow Charlie on twitter here.


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