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Talking Points:

  • The CBOE's SKEW index - a measure of 'tail' risk - slid to its lowest level since April 2016 as of Friday's close
  • There are an abundance of scheduled, discrete risks as well as unresolved thematic issues that create an uncertain environment
  • VIX and other implied measures have inherent flaws - as least as simplistic 'risk' measures - but does that extend to SKEW?

How do you evaluate 'risk' in individual trades or the market as a whole? What other measures can help with analysis of trades? Bring your trading, market and strategy questions to my weekly Trading Q&A webinar on Tuesday. You can find and sign up for it on the DailyFX Webinar Calendar.

There Have Been Some Peculiar 'Risk' Measures, But This...

Complacency can be a powerful emotion - sometimes overpowering greed and panic as the dominant sentiment. Such a perspective reflects an unreasonable degree of speculative calm (sometimes with an underlying bias) despite an abundance of fundamental inspiration to otherwise encourage speculative drive. Over the past years, we have seen the reach in speculative exposure translate into record highs for US equity indices despite uneven performance for a range of global risk assets, an unprecedented stretch of implied (expected) volatility for the medium-term at extreme lows (below a 10 reading) through 2017 and other remarkably unorthodox signs. However, through many of these untethered measures, it is particularly remarkable to see the CBOE's SKEW index register the deflating readings we have seen of late. Through the Friday update (it is a lagging indicator), we saw the so-called 'tail risk' reading drop to its lowest level since April 2016. It is perhaps not too surprising that the market is willing to discount the threats it may face, but it is quiet exceptional just how much fear is being digested to produce such a remarkable reading. Not only do we have the US mid-term elections immediately ahead, we have the FOMC rate decision this week with a remarkable bias in possible future outcomes, trade wars that put the US at odds with its global counterparts and a host of other domestic issues. Despite all that, we are left with readings that suggest a lack of concern that borders outright disinterest. Animal spirits can direct the market's in unusual ways but being fully disconnected from practical financial and economic reality is not sustainable.

SPX 500 vs. SKEW Chart (Daily)

The Lowest Fear of Extreme Market Moves in Over Two Years Despite Elections

The Issue in Evaluating Signals Rather than the Measures Themselves

Far fewer people are familiar with the CBOE's SKEW index than the more popular VIX volatility measure. For many, the popular indicator is the one and only measure of risk for which they need to refer. However, as widespread as the VIX may be, it has particular traits that can distort its signal and even be considered fatal flaws. First, it is important to understand the foundation of the measure. A medium-term, implied volatility derived from the S&P 500, this is a measure that draws from one of the favorite speculative measures across the global. This anticipation of activity is sourced from options on the index. In the historical and more academic context of traditional markets, equities were one of the few high risk, high return assets to make it to an acceptable portfolio. When market participants were looking to reduce risk, they would either unwind their exposure to shares or to hedge it. In general, the S&P 500 was considered a buy-and-hold asset class. That has changed as speculation has followed new strategies and access to new markets. Not only is shorting shares a more common approach to an active portfolio, but options are means to their own ends. This has distorted the signal that implied volatility backed out of these derivatives provide us. Whether through a record open interest in VIX futures or years of complacency encouraging the 'sell theta' strategy previously only pursued by options pros during periods of quiet, we need to think more critically of the measure rather than the signal it seems to provide.

SPX 500 vs. VIX Chart (Daily)

The Lowest Fear of Extreme Market Moves in Over Two Years Despite Elections

Environment Should Dictate More Than Catalysts and Indicators

In a world where irrationality runs rampant, it is important to take simple indicators with more than a grain of salt. In the context of a financial system that registers unreasonably low levels of risk in pursuit of slightly more yield, we learn more in the nature of market stability than any temporary opportunity that such an indicator may signal. There is explicitly an abundance of far-reaching financial threats across the global markets from trade wars to the recognition that extreme monetary policy has created unsustainable dependence for subsistence. While these issues may not meet their inevitable reckoning simply upon discovery by the average investor, they will eventually find balance - and more likely under periods of broader financial pressure that can hasten or ensure a more systemic collapse. With record risk exposure, remarkable distraction from wide-ranging fundamental threats, and unprecedented use of leverage across market participant type (investor, consumer, businesses and government); traders should remain wary despite what the traditional indicators suggest. We discuss risk between an extreme measure and underlying market conditions in today's Quick Take video.

S&P 500 and Leverage Chart

The Lowest Fear of Extreme Market Moves in Over Two Years Despite Elections

Written by John Kicklighter, Chief Currency Strategist for DailyFX.com