Don’t fret about elevated skew, vol experts say

Extreme relative cost of tail risk hedging is driven by flows more than fear

Downside equity skew — a measure sometimes taken as an indicator of nervousness in markets — has reached all-time highs, leaving investors wondering whether they should worry. Volatility experts say not. In fact, high skew may present an opportunity.

Rather than signalling trouble ahead, the extreme skew is due mostly to market flows, the experts argue.

“The volatility surface is always about how supply and demand interact,” says Yanko Punchev, senior portfolio manager at €50 billion asset manager Tecta Invest in Germany. “It doesn’t reflect expectations or the nervousness of investors.”

Alexis Maubourguet, who runs a $250 million absolute return fund at Lombard Odier Investment Managers, says the effect is down to options markets that are poorly arbitraged, in which derivatives flows driven by regulatory needs, for example, or by hedging of larger opposite positions, can have a “huge impact on secondary parameters like skew”.

“The market is not deep enough to digest the flows,” he says.

The cost of hedges in absolute terms has returned to normal levels in recent months, suggesting investor expectations have settled since last year’s Covid-driven turmoil.

One-year implied at-the-money volatility on the S&P 500 stood 18.2% on July 22, down from 41% in March 2020 and in line with its 15-year average of 18.9%, data from Societe Generale shows.

Some asset managers, then, are looking to take advantage of the market dislocation by adding to short skew positions or risk-reversal trades that fund upside exposure by selling downside protection. Banks are pitching strategies that systematically short deep out-of-the-money puts. 

Skewy markets

Skew captures the relative cost of hedging extreme market crashes compared with lesser falls.

Measured as the difference in implied volatility of an 80% out-of-the-money one-year put option on the S&P 500 versus an at-the-money option, skew reached more than eight percentage points in July – as high as at any time since 2010. The measure averages below seven percentage points and has traded as low as 5.5. 

 

 

The elevated levels have captured investor attention. At certain points when skew reached high levels in the past, such as in 2017 and 2018, markets have gone on to register sharp falls. But the relationship is inconsistent. In other instances where skew climbed, such as in mid-2016, markets stayed smooth.

This time, volatility traders say high skew levels have little to do with expectations of choppiness ahead. Demand from hedgers looking to lock in profits is high, the experts say. At the same time volatility selling is limited, both from investors and from banks.

“On one side you’ve got less supply and on the other you’ve got more demand,” Maubourguet says. “No wonder tail risk hedging and skew are very expensive.”

The 17% run-up in equities since the start of the year has fuelled hedging from institutional investors seeking to lock in gains, Punchev says. “After a rally, the big players tend naturally to seek to lock in profits.”

The recent positive correlation between stocks and bonds in the US has also fuelled hedging because bonds no longer provide reliable protection, according to Stuart Pyott, an institutional derivatives trader at Optiver, the options market maker.

After a rally, the big players tend naturally to seek to lock in profits

Yanko Punchev, Tecta Invest

Volatility sellers, meanwhile, have pulled back. The addition of the Covid selloff as a volatility datapoint in risk calculations such as value-at-risk means short volatility strategies have got harder to justify to risk-managers.

Covid has left “scar tissue” in options markets, Pyott says. Important volatility sellers, such as European volatility boutique RP Gamma and New York-based hedge fund Malachite Capital have shuttered.

Banks that have written large volumes of options for institutions this year, meanwhile, have built up exposure to tail risk, curbing both their willingness and ability to sell more protection.

Because hedges to lock in asset manager gains are struck far out of the money, they amount to a “massive gamma trade”, Punchev says, meaning a market slide could generate ballooning losses. 

At the same time, Covid has forced a repricing of tail risk at banks too. “After the Covid selloff, the perceived frequency of tail events has increased, and that flows into the banks’ options pricing models,” he says.

Adjustments

For hedgers, the skew is driving changes in behaviour, though any savings come on top of reduced overall hedging costs owing to lower implied volatility across the board.

Optiver’s Pyott says more hedgers are favouring put spread trades, in which firms sell tail protection to reduce the net premium of the overall structure.

Some buy-siders told Risk.net they had switched to options replication using futures, because tail protection using puts looks relatively pricey.

On the investing side, meanwhile, the extreme skew brings opportunity.

Implemented in a healthy and robust way, it is a useful contribution to balance an absolute return portfolio and generate returns

Alexis Maubourguet, Lombard Odier Investment Managers

Skew trades are now one of the largest allocations in Maubourguet’s portfolio at Lombard Odier, he says. “Implemented in a healthy and robust way, it is a useful contribution to balance an absolute return portfolio and generate returns.”

Short skew positions profit if the difference in implied volatility between at-the-money and out-of-the money puts compresses. But the trades can make money even if skew remains high because of the positive carry.

Investors go short higher volatility strikes and long lower volatility strikes and so receive more theta income – from the time decay of the options – on the short positions than they pay on the longs.

In a market rally the trade naturally generates a long volatility position that can be monetized through gamma hedging or selling vega, Maubourguet explains.

Banks, meanwhile, are plugging tail-risk selling strategies that have fared well in recent months.

At Societe Generale, Sandrine Ungari, head of cross-asset quantitative research, says a strategy selling deep out-of-the-money one-week puts has delivered a Sharpe ratio of more than five since July last year.

The premium on the options goes up when markets experience short bursts of volatility, which has continued to be the case despite the rally of the past year, she says.

Tecta Invest is considering buying risk reversals, in which investors sell puts to fund buying calls, Punchev says. “You can sell a put and buy two calls, essentially at zero cost.”

It’s a useful tool for adding tactically to risk over short periods, he says. The upside optionality means the trade can earn more than a futures position — the conventional tool for such tactical adjustments — while the downside is the same as for futures.