The S&P 500 index edged higher late Thursday, poised to potentially set another record closing high. However, the options market is flashing a cautionary signal: the "skew" indicator, which measures investor demand for downside protection, is sliding toward a two-year low. Analysis firm Tier1 Alpha notes this indicates a severe contraction in demand for put options as U.S. stocks continue to hit new highs, suggesting the market is sinking into "extreme complacency."

In a report, Tier1 Alpha pointed out that the skew for S&P 500 index options is declining, approaching its lowest level in two years. Skew refers to the difference in implied volatility between out-of-the-money put options and out-of-the-money call options, typically reflecting the premium investors are willing to pay to hedge against downside risk. A low skew implies that insurance against market declines has become relatively cheap and demand for it has weakened.

Regarding overall market volatility, a previous Cboe report also noted that as market focus shifted from macroeconomic risks back to AI-related trading, demand for call options surged significantly, while demand for put options fell to lower levels. With the SPX index at historic highs, market participants seem to broadly believe that "every dip is a buying opportunity." However, extremely low skew has often been a leading indicator of impending increased market volatility.

It is noteworthy that while the options market overall exhibits complacency, individual stocks are experiencing intense divergence. Data shows the average volatility for individual stocks within the S&P 500 is as high as 10%, while the index itself shows little movement. This divergence between a "calm index and turbulent stocks" suggests that capital flowing into large-cap weighted stocks is being used to hedge risks in other holdings. Furthermore, the market's support levels appear relatively clear. Option signals indicate active selling of June-expiry put options at the 7000 strike level, suggesting large institutions view the S&P 500 as having strong support above that point.

Given that the cost of downside hedging is at its lowest level in a year and a half, some strategists believe the current environment presents a window to purchase cheap insurance. Goldman Sachs' derivatives desk also noted that 3-month put options are currently priced at relatively low levels. However, Tier1 Alpha's warning is that as the momentum from systematic buying wanes, a reversal in market sentiment could cause the extreme skew to rapidly revert to its mean, amplifying downside market volatility.