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We beat everything VIX to death around these parts, but there’s one angle we need to get up to speed on: skew and how it impacts the CBOE Volatility Index (VIX) you see on the board.

Skew (in the options world) refers to the fact that different options strikes trade at different volatility, even within the same expiration cycle. Specifically, lower strikes almost always trade at a higher volatility than higher strikes, sometimes remarkably so.

Take S&P 500 Index (SPX) from Friday. It closed near 1,135. The June 1,110 line closed with an implied volatility of roughly 28, while the June 1,160 line closed at an implied volatility of about 20.5.

Now this makes perfect sense. Everyone fears the downside and, thus, bids up for protection. But it makes quite a difference when you see how it impacts the VIX.

The VIX uses a set formula based on the volatility of each qualifying SPX option. It normalizes to create a 30-day option, so it will incorporate the two nearest expiration cycles, up until the nearer one gets within eight days of expiration, at which time it leaves the calculation. We are within eight days of May expiration now, so the VIX only looks at June options for the moment.

The next thing it does is weigh the options such that closer strikes carry more weight. And that’s where skew comes into play.

Let’s say SPX starts near 1,160, a strike who’s options trade at about a 20.5 volatility. The June 1,160 line has a relatively large impact on the VIX calculation, and the June 1,110 line and its 28 volatility has a relatively small impact on the VIX calculation. Just to pick a number, let’s say this translates to a VIX of 23.

Now, suppose SPX drops to 1,110, but no volatility on an individual option changes. In other words, there’s not one iota more or less of fear than there was at 1,160. Now the June 1,110s have a big influence on the VIX, while the June 1,160s have a small one. The VIX has certainly lifted, we’ll conservatively say to 26.

So we have a situation where the market moved, and the VIX jumped over 10%, but yet nothing has really changed. All we did was move down the skew curve that already existed.

What I’m trying to say is that many of these VIX tweaks are simply mathematical. Skew is on the high side right now, so the effect is particularly pronounced at the moment. But for a guy simply trading SPX options and not caring about the VIX, he would not detect any change in volatility.

Now none of this is to say there’s not a real uptick of fear lately. The steepness of the skew curve in and of itself is a sign of increased fear. Additionally, in a calmer market, the SPX options board would adjust quicker. In other words, an at-the-money (ATM) option now would soon carry the volatility of an ATM option at a different SPX price, and the skew effect would be minimal after a day or two. I’m just saying that on a tick-by-tick, and even day-by-day basis, some of this “volatility of volatility” overstates how fast options are actually moving around right now.

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