Cumberland Advisors Market Commentary – Black Swan and SKEW

Author: Leo Chen, Ph.D., Post Date: May 5, 2020

The term black swan refers to rare events that are unpredictable in nature. These events are mathematically difficult to compute and statistically insignificant. Black Monday on October 19, 1987, is a typical example. One may consider the COVID-19 pandemic a black swan as well.

CBOE launched the SKEW Index in 1990, and it has been considered the black-swan index in finance. Normally, SKEW above the 150 level is taken as a black-swan signal, indicating that a catastrophic event might happen during the next 30 days, with a nontrivial probability.

To dig a little deeper, the SKEW Index uses out-of-money options to track the S&P 500 tail risk. Tail risk rarely happens, but it hurts when it does happen. The circled area in Figure 1 points to those uncommon returns. Unless they are gamblers, most agents use those out-of-money options as a hedging position, particularly if they are deeply out-of-money. Hence, we can extrapolate key information on how the market perceives the forward-looking underlying risk through those options. SKEW ranges between 100 and 150 most of the time. At close to the 100 level, black-swan concern is negligible; at the 150 level there is over a 15% probability that a large downside return might happen.

Figure 1. S&P 500 One-Month Log Return & Normal Return, 1990–2009, Same Mean and Std. Deviation as S&P 500.

The SKEW didn’t hit 150 until June 28, 2016. In the two and half decades prior to that, it had had been above 146 level on only three occasions. (The probability of a black swan event is roughly 14.5% at 146.) The first occurrence was on October 16, 1998, one day after the Fed decreased the target fund rate and discount rate in the middle of the Russian financial crisis and Long-Term Capital Management collapse. The next one was on September 19, 2014, after the Fed pledged to keep interest rates near zero for “a considerable time.” The last one was on December 11, 2015, days before the anticipated Fed rate-hike meeting, as crude oil fell below $36 a barrel to a new seven-year low. On that occasion, we find that the one-month S&P 500 return was quite violent in both directions. But the market was less volatile and turned positive in the ensuing 6-month period. Interestingly, there was no black swan event after June 28, 2016, though the Brexit referendum occurred just five days prior. The SKEW index has hit above 150 14 times since then, although there were no black swan events within 30 days after each time. The latest 150 level was read on December 19, 2019. The post-150 returns are mixed in the short term, while positive in the long term.

The returns are not surprising, as the 15% probability of a black swan is still a low figure, after all. This is not to deny the efficacy of SKEW. However, SKEW has been unbelievably suppressed throughout the COVID-19 sell-off. It briefly touched the 140 level in mid-February and dropped to 110 afterwards. So is SKEW accurate? In our view, SKEW is merely a reflection of market perception through traders’ lenses; obviously, it cannot be a trading indicator from the absolute point of view.

Leo Chen, Ph.D.
Portfolio Manager & Quantitative Strategist
Email | Bio

Links to other websites or electronic media controlled or offered by Third-Parties (non-affiliates of Cumberland Advisors) are provided only as a reference and courtesy to our users. Cumberland Advisors has no control over such websites, does not recommend or endorse any opinions, ideas, products, information, or content of such sites, and makes no warranties as to the accuracy, completeness, reliability or suitability of their content. Cumberland Advisors hereby disclaims liability for any information, materials, products or services posted or offered at any of the Third-Party websites. The Third-Party may have a privacy and/or security policy different from that of Cumberland Advisors. Therefore, please refer to the specific privacy and security policies of the Third-Party when accessing their websites.

Sign up for our FREE Cumberland Market Commentaries

Cumberland Advisors Market Commentaries offer insights and analysis on upcoming, important economic issues that potentially impact global financial markets. Our team shares their thinking on global economic developments, market news and other factors that often influence investment opportunities and strategies.

cumber map
Cumberland Advisors® is registered with the SEC under the Investment Advisers Act of 1940. All information contained herein is for informational purposes only and does not constitute a solicitation or offer to sell securities or investment advisory services. Such an offer can only be made in the states where Cumberland Advisors is either registered or is a Notice Filer or where an exemption from such registration or filing is available. New accounts will not be accepted unless and until all local regulations have been satisfied. This presentation does not purport to be a complete description of our performance or investment services. Please feel free to forward our commentaries (with proper attribution) to others who may be interested. It is not our intention to state or imply in any manner that past results and profitability is an indication of future performance. All material presented is compiled from sources believed to be reliable. However, accuracy cannot be guaranteed.