Technical indicators are statistics based upon a financial market's price and volume behavior. The somewhat obscure CBOE SKEW Index is one such indicator, measuring stock market bullish and bearish sentiment.
The index hit a generational high on Monday, signifying a strong surge in bearish sentiment. Historically, strong readings have been predictive of future price action on certain occasions, but have been ineffective predictors at other times.
This high SKEW reading came about because of the willingness of certain option buyers, put buyers in this case, to pay unusually rich purchase prices. This is a typically defensive move.
The two basic types of options are calls and puts. Calls give the buyer a right, but not obligation, to purchase an underlying asset, in this case futures contracts on the S&P 500 Index, at a set price (the strike price) on or before the call's expiration date.
The call buyer profits when the underlying asset's price exceeds the strike price, because the buyer can exercise the call (buy the asset at the strike price) and then immediately sell the underlying at the current price, locking in a gain.
The cost of the call, known as its premium, is determined by a number of factors, including time until expiration and "moneyness" (the relationship between the call's strike price and the underlying's current market price).
A call's premium is composed of two components:
1. Intrinsic value: the amount, if any, by which the current underlying's price exceeds the call's strike price.
2. Time value: an extra amount based upon the amount of time until the call's expiration. Time value dwindles as the expiration date approaches.
An in-the-money call is one with intrinsic value, whereas an out-of-the-money call has only time value.
Put options are the mirror image, giving the buyer the right to sell an underlying asset at the strike price. They are profitable when the underlying's price falls below the put's strike price.
Puts are often used as insurance against falling prices.
The CBOE SKEW Index indicates traders' perceptions as to whether an extraordinary event, known as a "tail event" or a "black swan", is brewing.
The SKEW index value is formed by dividing the price of out-of-the-money put options on the S&P 500 Index by the price of out-of-the-money calls. Readings typically run from 100 to 150. At 100, the prices of puts and calls are about equal, so traders are not particularly worried about a black swan event.
A 150 reading indicates elevated fear of a market drop, since traders are willing to pay far more for puts than for calls. On October 12, the SKEW Index hit 148.92, the highest reading in about 20 years, indicated that stock traders were uncommonly spooked.
However, an analysis performed by Kimble Charting Solutions shows that the predictive ability of the SKEW Index is mixed. In other words, sometimes it's right and sometimes it's wrong.
This is an example of why technical analysts normally rely on a collection of indicators to make predictions. Time will tell whether Monday's reading has any lasting significance.