Implied Volatility and Voltaility Skew in Equity Index

spanish version

This time, the idea is to take a look at the volatility implied in the options and the volatility skew of different Indices around the world.

In the following table we can see the volatility implied in the one month maturity options, this mean the market expectation about the next month volatility of the different Indices. So, as we can see, the Indices perceived by the market as the highest volatile during the next month were Russia and Italy, both with an Implied Volatility greater than 30 points.

Furthermore, Italy showed a historically high volatility level (76%-ile[1]) with an increase of 20% from the previous month (5.7 volatility points). Same behavior showed all the Euro Area Indices with an average increase of 5.5 v.p., denoting an increase in the risk perception of this area in general.

On the other hand, Switzerland was the Index perceived as the less volatile for the next month and despite its volatility increase from the last month, it was in historically low levels (15%-ile). On overall, the perception of volatility in the equity markets increase in 2.1 v.p. since the previous month.

Options Volatility Screener

Another important variable to take a look at, in order to have a complete understanding about volatility, is the skew, defined here as the difference between the 25 delta implied volatility (IV) in puts and calls options normalized by the 50 delta IV. So the higher this value the more expensive, in terms of the Black-Scholes model, the puts are over the calls.

We can think about the skew as a measure of:

- Risk aversion: as the skew increase, the market players are hedging more positions by buying OTM puts and selling OTM calls, so the participants are becoming more risk averted.

- Relative tail events probability: as the skew become higher, the investors are paying more for OTM puts than for OTM calls meaning that their perception about the probability of a negative tail event relative to the positive one is more likely.

So we can think that changes in the Skew denoted changes in the risk aversion of the market players and changes in their perception about tail risk probabilities.

In particular, the Canada Index and the S&P 500 are the ones that show the bigger Skew in their options volatility. However, the Indices that are more skewed relative to the last four years were the Nasdaq and the Kospi 200, close to the 65%-ile. On the other hand, it is interesting to remark that most of the European Indices showed their Skew below the 10%-ile, values that look contradictory with the actual situation of Europe.

However, if we take a look at the evolution of these values, we find out that on average these countries reduce its skew about 50% (0.07 skew points) in the last month. One possible posible explanation of that could be the announcement of the ECB’s president Mario Draghi, saying that the ECB is going to make whatever it takes to preserve the euro. This means that the ECB is going to be there if a negative tail event would happen, reducing the probability of a negative tail event and with it the volatility skew.

In this direction, we are going to take a look at the evolution of the S&P 500 and the EuroStoxx 50 Skew, in order to see their reaction against the Monetary Easing announcements. As we can see, after each announcement both Skews show a reduction in their value. This makes sense because if you know that the FED or the ECB are injecting liquidity or purchasing assets, the negative tail event become less probable and the risk aversion goes down, producing a reduction in the skew.

Skew evolution and Monetary Easing

Another interesting thing we can see in the previous graph is that the correlation between the S&P 500 and EuroStoxx 50 was almost 80% in the last 4 years. However, in the last months these values separate from each other, with the EuroStoxx 50 Skew in the 5%-ile and the S&P 500 above the 50%-ile.

Based on this information, we can perform a relative trade on the skew of these Indices, even more if we know that this situation had happened several times in the past and on always these two values converged to the same value.

I invited you to create your own trading strategy based on this discrepancy. My strategy is coming soon.

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[1] Percentiles are calculated using data from February 2008 – July 2012