I continue to "obsess" about the volatility skew. For those new to the skew and what is means please read here first. After the May 2010 correction the skew and vix both converged and continued to correlate for the most part through August 2010. Since that time they have diverged as some investors began buying further out of the money options versus the masses who continue to sell volatility whether as a form of speculation (selling puts) or simply ignoring the need for portfolio insurance.

The divergence grew to an extreme in February 2011 which preceded the market correction and then markets moved higher yet unlike 2010 the skew and vix did not correlate but instead diverged again. When the current selloff began the skew would come down as the vix would rise yet each move lower in the skew is followed by a sharp move higher (first chart below).

This brings me to the second chart showing the skew and vix divergence versus the SPX. The correlation is unquestionable even in the presence of QE where other correlations have broken. What intrigues me now is the trend in the divergence how it continues to trend lower although from elevated levels. Until the trend reverses it appears the skew will continue to move higher each day the market bounces. In other words as the vix remains elevated and possibly breaking out, the skew continues to confirm the level of complacency still within the equity markets.

By Tony Pallotta

http://macrostory.com/

Bio: A Boston native, I now live in Denver, Colorado with my wife and two little girls. I trade for a living and primarily focus on options. I love selling theta and vega and taking the other side of a trade. I have a solid technical analysis background but much prefer the macro trade. Being able to combine both skills and an understanding of my "emotional capital" has helped me in my career.

© 2011 Copyright Tony Pallotta - Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.

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