Investor sentiment can be a fickle thing during the best of times. When the global economy is thrown into upheaval and uncertainty, it gets even worse. Traders on Wall Street are typically inclined to be bullish because that is how the stock market is set up. Stocks are made to increase in value as the companies that issue them expand and thrive.

However, traders also tend to worry about their investments. Other market participants typically lose confidence when they are uncertain about the future and the stock market goes down.

To help gauge investor sentiment — whether it is bullish or bearish — analysts often turn to the CBOE Volatility Index (VIX) and the CBOE SKEW Index (SKEW).

The CBOE Volatility Index (VIX)

The VIX is a market sentiment indicator that looks at the value of out-of-the-money (OTM) put options and OTM call options on the S&P 500 to determine how much volatility investors anticipate in the market in the near future. For a detailed explanation of how the VIX is calculated, check out this white paper from the CBOE.

When the VIX is moving lower, it shows traders are becoming less concerned about potential bearish reversals. The less concerned they are, the fewer put options on the S&P 500 they buy. Less put buying pushes the value of those options lower, which pushes the VIX lower.

When the VIX is moving higher, it shows traders are becoming more concerned about potential bearish reversals. The more concerned they are, the more put options on the S&P 500 they buy. More put buying pushes the value of those options higher, which pushes the VIX higher.

You can see a great example of how the market’s level of concern fluctuates over time in the VIX chart in Fig. 1.

Fig. 1 — Daily Chart of the CBOE Volatility Index (VIX) 

In early 2020, traders weren’t too concerned the market was going to experience a large move to the downside. The VIX remained in a relatively low range between 12 and 20. All that changed in late February. Traders began to realize the potential impact the novel coronavirus could have on the global economy.

The VIX started rising and reached its recent closing high of 82.7 on March 16.

The CBOE SKEW Index

The SKEW is another market sentiment indicator — similar to the VIX — that relies on out-of-the-money (OTM) options prices. The SKEW looks at the difference in the value of OTM put options and OTM call options on the S&P 500 to determine how much more traders are willing to pay for deep OTM put options than they are for less deep OTM put options and OTM call options.

Since the market crash of 1987, the relationship between the value of OTM puts and OTM calls has been skewed toward puts.

Traders are naturally more worried about the risk of a bearish market pullback than they are about a bullish market surge. So, they are willing to pay more for deep OTM puts than they are for deep OTM calls. The CBOE also has a detailed explanation of how the SKEW is calculated in this white paper.

When the SKEW is moving lower, it shows traders are less convinced a bearish move lower is more likely than a bullish move higher.

The less convinced they are, the less likely they are to pay a premium for deep OTM put options on the S&P 500. In contrast, they may be willing to pay more for deep OTM call options. This decreases the skew, or imbalance, between the value of the OTM put options and the OTM call options. It then pushes the SKEW closer to 100 — the point at which put and call values are in equilibrium.

When the SKEW is moving higher, it shows traders are more convinced a bearish move lower is more likely than a bullish move higher.

The more convinced they are, the more likely they are to pay a premium for deep OTM put options on the S&P 500, especially compared to what they are willing to pay for deep OTM call options. This increases the skew, or imbalance, between the value of the OTM put options and the OTM call options. It then pushes the SKEW farther away from 100.

You can see a great example of how the market’s level of concern fluctuates over time in the SKEW chart in Fig. 2.

Fig. 2 — Daily Chart of the CBOE SKEW Index (SKEW)

Interestingly, the SKEW was much higher in late 2019 and early 2020 than it has been since concerns over the coronavirus surfaced in the market in late February. This move lower shows the dramatic level of uncertainty about what was going to happen to the S&P 500.

Covid-19 and Market Sentiment

At first blush, you probably would have expected to see the SKEW soaring higher along with the VIX. You would think that traders would be more willing to pay a premium for deep OTM put options on the S&P 500 during the crisis.

However, as the S&P 500 started to fall, there were just as many traders who were willing to pay a premium for deep OTM call options on the index because they believed the market was going to experience a V-shaped rally in the short term.

The SKEW bottomed out on March 18, right about the time the S&P 500 reached its 52-week low of 2,191.86 on March 23 (see Fig. 3).

Fig. 3 — Daily Chart of the S&P 500 (SPX)

Since then, the SKEW has been rising while the VIX has been falling. This tells us that overall volatility levels have been declining, but traders have been more willing to pay a premium for deep OTM put options during the past two months than they have for deep OTM call options.

In other words, traders have been hedging their portfolios to protect them from both bullish and bearish swings.

During the early part of the Covid-19 crisis, traders were selling their stock holdings and shorting other stocks. But they were also hedging against a potential bullish reversal. This meant they were willing to pay a higher premium for deep OTM calls.

As the crisis wore on, and as traders began buying stocks again and closing out their short positions, they have been willing to pay a higher premium for deep OTM puts. They have been hedging against a potential bearish reversal.

The Bottom Line on Options

Looking at the SKEW chart in Fig. 2, it appears traders are shifting sentiment once again. The SKEW is starting to move lower, which tells us traders are starting to pay more for deep OTM calls.

If the contrarian trend we have seen so far through this health crisis continues, this could be a sign that traders are gearing up to take profits on their stock positions but want to be protected just in case the S&P 500 jumps higher again.

We’ll be watching short-term support on the S&P 500 at around 2,800 (see Fig. 3). If this level fails to hold, the index will have confirmed a “double-top” bearish reversal pattern. This could mean further downside in the near term.

We’ll also be watching to see if the VIX starts to move higher once again.

John Jagerson & Wade Hansen are just two guys with a passion for helping investors gain confidence — and make bigger profits with options. In just 15 months, John & Wade achieved an amazing feat: 100 straight winners — making money on every single trade. If that sounds like a good strategy, go here to find out how they did it. John & Wade do not own the aforementioned securities.