Tail-risk hedging surge looms over U.S. rally

The underbelly of the options market is flashing a warning sign for U.S. stock bulls.

As global trade skirmishes intensify and valuation fears stalk technology stocks, investors are forking over cash for tail-risk protection, even as Wall Street’s traditional fear gauge sits at muted levels.

The Cboe SKEW Index breached 150 last week, reflecting a surge in demand for out-of-the-money put options versus calls on the S&P 500 Index. The SKEW is on track to notch its highest average closing level in history this year, according to data compiled by Bloomberg going back to 1990.

“This has everything to do with trade risk in my view,” said Dennis DeBusschere, the head of portfolio strategy at Evercore ISI.

Beijing said it will reject new trade talks if U.S. President Donald Trump moves ahead with the next round of U.S. tariffs on Chinese products, throwing into doubt the prospect of a diplomatic breakthrough, according to two people familiar with the matter.

Historically, the SKEW has hovered around 115, reflecting structurally higher demand for puts over calls. On Friday, it closed at 151.6. To bears, the elevated level is evidence that a blow-up in U.S. stocks — returns two or more standard deviations below the mean — may be nigh.

Another interpretation? Derivatives traders aren’t inclined to bet stocks will surge higher.

The index could merely be signalling that demand for out-of-the-money calls is weakening after the S&P 500’s 12 per cent recovery from a February low. Rather than fretting a catastrophic downturn, investors may simply fail to see much upside.

“$SKEW at current levels not necessarily a bearish sign; rather an indication for lack of bullishness,” Yannis Couletsis, director at volatility hedge fund Credence Capital Management Ltd., said in a tweet.

There’s another reason doom-mongers shouldn’t read too much into it: The gauge hasn’t been particularly good at predicting downdrafts. In the run-up to February’s two-day, 6 per cent dive in the S&P 500 for instance, the SKEW was actually falling, suggesting investors were oblivious to risks.

Back then, outsized demand for out-of-the-money call options — which would have dragged down the SKEW gauge — could have been the culprit, as analysts priced in the benefits of U.S. tax cuts.

Pravit Chintawongvanich, equity derivatives strategist at Wells Fargo Securities, urges caution. The SKEW index is “very, very, noisy,” and can be buffeted by price movements in relatively illiquid options that are well out-of-the-money, he says.

All the same, investors seem focused on the threats to global markets just now. A trade war, quantitative tightening and political populism are among the largest tail risks, according to Bank of America Corp.’s survey of fund managers last month.