Have You Heard The One About The Dirty Shirt And The Flat Skew?

Last week, Goldman suggested it might be time for investors to hedge. Their rationale is as follows:

We believe the VIX spike in early February was a significant event for investors, made even more significant last week as we revisited the YTD lows in the S&P 500. S&P 500 realized volatility was 6.8 in 2017 and has nearly tripled to 20.3 thus far in 2018. We expect the increase in realized volatility to have direct effects on the calculation of risk in a variety of equity portfolios (when volatility rises, position sizes need to decrease to maintain the same dollar-volatility risk). The spike in VIX and realized volatility was large enough for investors outside the equity market to take notice and could lead to a reduction in risk-taking appetite on the margin in the coming months. It was yet another symptom of the market fragility created by lower liquidity. We believe that a shift towards risk reduction and expectation of higher volatility is likely to change the trading dynamics in 2018 and increase the value of time spent on hedging.

Ok, sounds plausible, right? Goldman even went so far as to provide you with a handy bullet point list of tautological hedging instructions like “hedge when you think the risk is greatest” – that’s in case you don’t know what hedges is or what they does (to borrow a deliberate grammar error in the service of humor from Thornton’s regulation headline).

Goldman would go on to say that “more recently, open interest data reveals that a large number of S&P 500 hedges have expired over the past three weeks, leaving the average investor less hedged.”


Bloomberg’s Dani Burger picked up on that theme for a recent piece, noting that the Cboe SKEW Index “has been falling for the last two weeks, and is now two standard deviations below its average level [while] another options-based gauge, the Credit Suisse Fear Barometer, hit its lowest level since 2016 on Monday.”

“At face value, the current level of the Skew Index may represent a lack of concern around an imminent left-side ‘tail risk,’” Burger quotes Olivetree Financial’s Tim Emmott as saying, in a Tuesday note to clients.

Well with all of that in mind, it’s worth excerpting a few passages from a Thursday note by Macro Risk Advisors Pravit Chintawongvanich who writes that “ironically, a greater willingness to own option premium may be driving a flatter skew.”

Chintawongvanich begins by showing you the flattening, which comes even as volatility rises and stocks fall:

As you can see below, skew (here we use the VIX to SPX 1-month at-the-money volatility spread) has steadily decreased over the past month, even as the S&P sold off and 1-month at-the-money volatility rose. This is contrary to what it did in the initial February selloff, when skew was extremely well bid.


That, Pravit says, does not betray a lack of enthusiasm for hedging. Rather, for  Chintawongvanich, it represents something of an epochal shift in market psychology. This is where the “irony” noted above comes in:

Consider that 1-month at-the-money implied, which has been in the 17-20 range over the past few weeks, is lower than 1-month, 2-month, and 3-month realized. This is the first time in a long time that options have carried positively for a sustained amount of time — owning ‘gamma’ is paying! 


Ok, so as Chintawongvanich goes on to note, “if you think owning gamma is going to pay — then the best thing to own is at-the-money options or even upside options.”

In the same vein (sort of), Pravit talks about what he’s calling the “dirty shirt effect” which is basically that once shit has already hit the fan like it did in February, it’s not clear how much worse things can get and how quickly (in the terms of higher realized vol.) assuming equities continue to decline. Here’s something about messy meals and a hypothetical guy who inexplicably decides to wear a “spotlessly clean white shirt” while eating messy food:

Think about it this way: in January when the VIX was 10 and S&P was at the highs, it was like trying to eat a messy meal while wearing a spotlessly clean white shirt. You would be very careful not to get your shirt dirty. But on Feb 5th, you spill an entire plate of food all over your shirt! After ruining your shirt, you wouldn’t be so careful about making it even more dirty. In other words, the “skew premium” of staining your shirt is gone. The potential transition from clean shirt to dirty shirt (low vol to high vol) necessitates a higher skew premium than dirty shirt to even dirtier shirt (high vol to even higher vol).


I’m not sure that’s the best analogy (no one likes to think about spilling spaghetti on a white YSL shirt), but it does the trick in terms of getting the point across.

Pravit’s conclusion is that investors should actually think about trading the “flat skew” on the call side because “even if the market continues to be volatile, it’s tough to say any bid will emerge to downside skew, and it could be even tougher to monetize it, depending on the path markets take.”


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