Back in 1994, during that memorable Fed tightening cycle, every time the Fed tightened, the market priced in a greater probability of more and faster tightening. Chairman Greenspan referred to the Eurodollar futures market as "A blind man looking into the mirror."
Similarly, I do not think looking at Skew index will help you systematically avoid risk and make money for similar reasons -- namely, it is self-referential. At the risk of articulating an Epistemology, any market price that is set by market participants cannot correctly discount the probabilities of something that isn't correctly discounted. I know that sounds like a typo, but it isn't. It's the nature of arbitrage-free pricing.
To say that "high skew means cut back exposure" is way too simplistic and it is what gives rise to the high skew in the first place. It's similar to market participants who adjust exposure based solely on VaR -- they take more risk when things "look" safe and reduce risk when things "look" dangerous -- with the blessing of academics and statisticians and other wonks. In contrast, many successful investors do the exact opposite: they reduce exposure when things look safe and increase exposure when things look dangerous.
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I've never study the composition of VIX, but I have always wanted to ask this question: wouldn't VIX be catagorised as 'self-referential' as per your paragraph I have quoted.
To my simple mind it is a completely 'virtual' measure ie there are no hard assets (like oil, or shares) that determine it's value. In fact the VIX value is just the summation of all the participants views about volatility - hence self-referential.
Or maybe I am completely off track and VIX is actually compiled/calculated some other way.
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you're right in the sense that the vix weights near-the-money options more heavily than out-of-money options. . because options skews almost always imply more downside volatility for stocks than upside volatility, when the market declines it tends to bring more “high volatility” strikes into play and so part of the vix increase in a down market is simply mechanical. the market is full of these feedback loops where there is a non-linear relationship between cause and effect. any point on the loop is both an effect of the previous cause, and a cause of the next effect. soros contends that the stock market itself is such a self-referential system, and is the basis of his theory of reflexivity.
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