‘Black Swan Risk Canary’ Soars to All-Time High

Many times catchy headlines do not deliver any content even remotely as interesting as the title. But this catch headline is backed up by one of the most accurate stock market indicators in recent years.

What’s the ‘Black Swan Canary?’ It’s the CBOE SKEW Index.

The SKEW Index is calculated by the CBOE. The CBOE, the same outfit responsible for the CBOE VIX.

According to CBOE, the SKEW Index is designed to measure the tail risk (= risk of outlier returns two or more standard deviations below the mean) of the S&P 500.

The SKEW Index basically estimates the probability of a large decline or ‘Black Swan’ event.

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Similar to the CBOE VIX or VIX Volatility Index (NYSEArca: VXX), the price of the S&P 500 (NYSEArca: SPY) tail risk is calculated from the price of S&P 500 out-of-the-money options.

The SKEW typically ranges from 115 to 135. Readings of 135+ suggest a 12% chance of a large decline (2 standard deviations). Readings of 115 or less suggest a 6% chance of a large decline.

The highest SKEW reading was recorded on October 16, 1998 and was matched by last Friday’s spike to 146 (the chart below was originally published in Sunday’s Profit Radar Report).

Here are probably the two most salient points about the SKEW/S&P 500 relationship:

  1. The SKEW has established a sequence of higher highs. It has taken progressively higher SKEW readings to get the S&P 500 in trouble (134 in April 2010 was enough to ‘cause’ the ‘Flash Crash’. 143 in December 2014 only led to a minor eventual pullback).
  2. Nevertheless, an elevated SKEW has tripped the S&P 500 (at least to some extent) every time. If this track record continues, Friday’s SKEW spike should cause some choppiness.

Although the 2010 and 2011 corrections were quite nasty, the label ‘Black Swan Index’ has been misleading in recent years.

This time may be different, but the SKEW has been one of the most accurate indicators in an environment that’s fooled many other trusted gauges.

The SKEW suggests a bumpy ride ahead with limited gains and elevated risk.

I always recommend looking at more than one indicator (I personally monitor various indicators from three different categories: Sentiment, seasonality and technicals).

The SKEW’s meaning is nicely enhanced by a simple Dow Jones (NYSEArca: DIA) chart. Right now a rare Dow formation offers clear levels of ruin and opportunity.

Simon Maierhofer is the publisher of the Profit Radar Report. The Profit Radar Report presents complex market analysis (S&P 500, Dow Jones, gold, silver, euro and bonds) in an easy format. Technical analysis, sentiment indicators, seasonal patterns and common sense are all wrapped up into two or more easy-to-read weekly updates. All Profit Radar Report recommendations resulted in a 59.51% net gain in 2013.

Follow Simon on Twitter @ iSPYETF or sign up for the FREE iSPYETF Newsletter to get actionable ETF trade ideas delivered for free.

Equity Put/Call Ratio at 41-Month Low, but Risk of ‘Black Swan’ Event Limited

Last week the CBOE Equity Put/Call ratio slipped as low as 0.43, the lowest level since January 2011. Similar readings in April 2010 and April 2012 led to nasty sell offs? But something is different this time.

Last week the CBOE Equity Put/Call ratio plunged to 0.43, the lowest reading since January 2011. This wasn’t just a one-day fluke as the 5-day SMA fell as low as 0.518, also a 41-month extreme.

A ratio of 0.43 means that option traders bought 2.3 calls (bullish option bet) for every put (bearish option bet). Option traders don’t have a ‘smart money’ reputation.

The chart below, featured in the June 11 Profit Radar Report, plots the S&P 500 (SNP: ^GSPC) against the 5-and 10-day SMA of CBOE Equity Put/Call ratio.

As the dashed red lines highlight, low put/call ratio levels led to S&P 500 (NYSEArca: SPY) weakness more often than not.

Is the Put/Call Ratio Warning of a Crash?

Lately, there’s been much talk about a crash or major correction. Does the current equity put/call ratio foreshadow such a crash or correction?

Looking at the put/call ratio in isolation one could conclude that there’s a high chance of a 1%+ correction. Why?

Similar equity put/call ratio readings in April 2010 and April 2012 were followed by nasty sell offs (see red shadows).

But let’s expand our analysis to include the CBOE SKEW Index. The SKEW Index basically estimates the probability of a large decline (2 standard deviations or ‘Black Swan’ event).

Readings of 135+ suggest a 12% chance of a large decline. Readings of 115 or less suggest a 6% chance of a large decline. In short, the higher the SKEW, the greater the risk for stocks.

Last week the SKEW finished at 127.78, which is above average, but well below its January peak of 139.62.

The April 2010 and April 2012 highs saw SKEW readings of 134 and 139 (shaded areas).

The relative SKEW anemia softens the generally bearish message of the put/call ratio, but it doesn’t eliminate all the risk.

The Profit Radar Report’s 2014 S&P 500 Forecast (published on January 15), projected a pre-summer high at S&P 1,950. Last week the S&P reached 1,950 and pulled back. What does this mean for the rest of the year?

A complimentary look at the updated 2014 S&P 500 Forecast is available here:

Updated 2014 S&P 500 Forecast

Simon Maierhofer is the publisher of the Profit Radar Report. The Profit Radar Report presents complex market analysis (S&P 500, Dow Jones, gold, silver, euro and bonds) in an easy format. Technical analysis, sentiment indicators, seasonal patterns and common sense are all wrapped up into two or more easy-to-read weekly updates. All Profit Radar Report recommendations resulted in a 59.51% net gain in 2013.

Follow Simon on Twitter @ iSPYETF or sign up for the FREE iSPYETF Newsletter to get actionable ETF trade ideas delivered for free.

Despite Extreme VIX Movements, Option Traders are ‘Lukewarm’

According to the VIX, option-traders are complacent and have been complacent for many months. The bearish VIX implications however, have not been confirmed by two historically accurate options-based sentiment indicators.

The VIX soared 43% on Monday, collapsed 19% on Tuesday and is up nearly 30% today. Just before that, the VIX fell to the lowest reading since February 2007.

Although the CBOE Volatility Index (VIX) is rushing from one extreme to the next, options traders as a whole have been remarkably ‘non-committal’ or lukewarm from a sentiment point of view.

This sentiment deviation is illustrated by the chart below. The CBOE Equity Put/Call Ratio has been narrowing in a triangle shape formation void of extremes. The 2010, 2011 and 2012 market highs were preceded by at least one daily reading below 0.5 and a drop of the 10-day SMA below or at least close to 0.55.

The 2013 Equity Put/Call Ratio low was at 0.54 on March 6 (the 10-SMA has yet to fall below 0.6). The recent all-time highs caused no put/call sentiment extremes.

Quite to the contrary, the VIX has rushed from one extreme to the next. For that reason, the Profit Radar Report noted back in November that the: “VIX has been of no use as a contrarian indicator and will be put on ‘probation’ until it proves its worth again.” Yes, the VIX is still on probation.

A SKEWed Market?

The CBOE publishes another options-based index like the VIX, it’s called the CBOE SKEW Index. The SKEW in essence estimates the probability of a large decline.

Readings of 135+ suggest a 12% chance of a large decline (two standard deviations). A reading of 115 or less suggests a 6% chance of a large decline. In short, the higher the SKEW, the greater the risk for stocks.

The chart below juxtaposes the SKEW against the S&P 500. Last week the SKEW fell as low as 117. This was odd as readings below 115 (dashed green line) are generally bullish for stocks.

Conclusion

The CBOE Equity Put/Call Ratio and SKEW index proved to be valuable contrarian indicators in 2010, 2011 and 2012. The current option-trader sentiment is not bullish, but it’s not as bearish as one would expect to see at a major market top.

To an extent, option-trader sentiment is in conflict with other bearish sentiment extremes discussed recently. When sentiment indicators conflict, technical analysis and support/resistance levels become even more valuable.

The April 10, Profit Radar Report highlighted key resistance at 1,593 and stated that: “A move above 1,593 followed by a move back below 1,590 will be a sell (as in go short) signal.”

As long as prices remain below key resistance, the trend is down until stocks find key support.