On February 5, 2018, on the heels of rising rate expectations, the S&P 500 dropped 4.1% recording its largest one-day move since 2011. This ended 300 trading days without a downward move of more than -2% in the index. The VIX, in turn, recorded its largest-ever percentage increase (115%) closing at 37.32 from the previous day’s close at 17.31. Additionally, stock correlations increased and reached their highest levels since August 2015.
Let’s begin by examining what happened to the volatility skew as the market sold off in early February. Remember from Part 1 that skew is the relative difference in pricing between downside strikes (moneyness less than 100%) and upside strikes (moneyness greater than 100%). The general theme in January was that of a declining skew as investors implemented stock replacement strategies via upside calls and overwriters were forced to cover their short call positions due to the speed of the market’s rally. The demand for upside calls increased with a rapidly rising market.
Things reversed dramatically in February. The graph below compares the skew curve from January 26 to the shape of the same skew curve from February 8, 2018.
Source: Bloomberg, Swan Global Investments
The graph above shows two things. First, there was an increase in overall volatility. This equates to ALL options increasing in value as a function of increased demand for option premium across the spectrum. Secondly, there was a marked increase in skew. In other words, not only was there an increase in demand across the board for option premium, but there was a relative increase in demand for downside puts as investors rushed to purchase protection as the markets sold off.
To showcase this further, the 25-delta put-call skew we saw on January 26 had traded in the 22nd percentile over the last 5 years. Meaning, over the last 5 years, 78% of all observations had skew trading higher. On February 8, 2018, that percentile had increased to the 100th percentile.