The Credit Suisse Fear Barometer, which measures the cost of protection against a market crash, is closing in on all time highs.
The index now sits just below its peak just before Brexit, and the investment bank has “gotten a lot of questions on what’s driving the sharp increase,” according to Mandy Xu, an equity derivatives strategist at the Swiss bank.
The CSFB is a measure of what’s called the three month skew in the S&P. Xu explained in a note:
“It is calculated by selling a 10% OTM [out-of-the-money] call on the S&P and using that premium to purchase downside protection. The level of the index indicates the %OTM strike of the put that makes the strategy net zero cost. A high CSFB reading signals high cost of protection relative to upside calls.
“If you break down the increase in S&P skew, you can see that while put demand has certainly increased over the past week, the biggest mover actually comes from the call-side.”
Options are a financial instrument a trader can use to make a bet on the market. To obtain an option, traders must pay a “premium” for the opportunity to own the options and be able to use them as a bet or a hedge. The Credit Suisse Fear Barometer measures those premium costs as they change with changes in supply and demand.
Credit Suisse notes that there is a noticeable decrease in the number of call options being bought and the premiums being paid for them. Buying call options indicates that a trader thinks the market is going higher.
Credit Suisse cites macro and political headwinds as a reason behind the move in the fear gauge. The options dates being bought and sold indicate that investors are very fearful of the potential risks associated with the French election and the US budget deadline.
The fear index that most investors usually think of is the CBOE Volatility index, also known as the VIX. The VIX is a measure of expectations of volatility in the options market. If traders are nervous, options become more expensive and the VIX rises.
The VIX has now reached its highest level in more than 100 days. In a note circulated April 12, Pravit Chintawongvanich of Macro Risk Advisors said that there is a gap between the actual realised volatility of the S&P and the VIX, which is called the “risk premium”. This premium tends to rise when the market knows of an upcoming event that could lead to significant volatility. Chintawongvanich said:
“We have seen a persistent bid to volatility in the past few days, even as the S&P remains mostly unchanged and actual realised volatility remains at low levels. 1-month realised volatility is barely 6.7. That 8+ point spread of VIX to 1-month realised volatility is near its highest levels in the past 5 years. But as we show below, the market can imply a high risk premium when it is an aware of an upcoming event, pushing option prices to elevated levels even when realised volatility is low. In this case, the upcoming macro catalyst is the French elections, but we saw a similar implied-realised spread blowout ahead of the Brexit referendum and the US elections.”
So in short, the VIX and the Credit Suisse Fear Index may be on the move for similar reasons.
The VIX closed higher again April 12 up 4.64% to 15.77.