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Volatility Futures Reach 19-Month High on S&P 500 Rally

Volatility Futures Reach 19-Month High After 24% S&P 500
The S&P 500 pit on the floor of the CME Group's Chicago Board of Trade. Photographer: Tim Boyle/Bloomberg

Futures traders are pricing in the biggest increase in U.S. equity hedging costs since 2010 after the Standard & Poor’s 500 Index rose within 2 points of erasing last year’s slump.

April futures on the Chicago Board Options Exchange Volatility Index settled at 25.15 yesterday, or 6.96 points higher than the level of the gauge, according to data compiled by Bloomberg. The gap widened to 7.02 points on Feb. 17. The last time two-month futures were that high in relation to the index known as the VIX was July 2010.

The S&P 500 has surged 24 percent since Oct. 3 on optimism Europe will resolve the debt crisis. Now, traders are increasing hedges to protect against losses, according to Dominic Salvino, a specialist on the CBOE floor for Group One Trading.

“The consensus bet is that we’re going to have turmoil or some levels of higher volatility in the future,” Liam Dalton, who oversees about $1.8 billion as chief executive officer of Axiom Capital Management Inc. in New York, said in a telephone interview yesterday. “If you were to talk about a breakdown in cooperation in Europe, it would affect everything. If the sentiment goes negative, then you can get these periods of increased volatility.”

The S&P 500 failed to hold above 1,363.61 yesterday, closing below the almost three-year high reached on April 29. The index retreated 19 percent between April and Oct. 3 as concern Greece would default, slowing global economic growth, intensified. Futures on the equity measure had rallied as much as 0.7 percent yesterday after European leaders agreed to give Greece 130 billion euros ($172 billion) in aid.

VIX Above 25

The VIX was unchanged at 18.19 today, down 62 percent from a more than two-year high of 48 reached on Aug. 8. The gauge stayed above its 22-year average of 20.56 for 117 days between July and January, the longest period since 2009, data compiled by Bloomberg show. All VIX futures expiring in April or later closed above 25 yesterday.

“Long-dated VIX has been stubbornly high,” Ralph Edwards, director of derivatives strategy at Investment Technology Group Inc. in New York, wrote in an e-mail yesterday. This is due in part to “the lack of willingness of people to sell long-dated contracts covering periods over which they have limited visibility,” he said.

Low valuations for U.S. stocks may help prevent losses for the S&P 500, even if volatility increases, according to David Steinberg, who manages about $300 million as founder of Chicago-based DLS Capital Management LLC.

Valuations Drop

The S&P 500 is approaching its cheapest level ever compared with bonds as Federal Reserve Chairman Ben S. Bernanke’s zero-percent interest rates drive investors and companies from cash. Profits that doubled since 2009 pushed the index’s so-called earnings yield to 7.1 percent, close to the highest on record when compared with the 10-year Treasury rate, according to data compiled by Bloomberg since 1962.

“Equities are undervalued,” Steinberg said yesterday in a telephone interview. “Investors are coming back to stocks now, but money isn’t flowing back into the market with the same velocity as when they flowed out, which is keeping the VIX fairly low. Stocks may continue to advance even if volatility should pick up.”

The VIX has tumbled 60 percent since the S&P 500 bottomed on Oct. 3, a record decline over the same number of days. Declines of 50 percent or more have preceded S&P 500 rallies of about 15 percent on average in the next year, data compiled by Bloomberg show. That compares with a rolling annual average increase of about 8.1 percent since 1990 for the equity gauge.

Credit Suisse Gauge

Another measure of concern among options traders rose to a record high last week as investors pay more for contracts that gain in value when equities fall. The Credit Suisse Fear Barometer, an index of the cost of buying three-month S&P 500 puts, funded by selling call options, rose to 30.50 on Feb. 16.

March 1,300 puts, which are priced 4.6 percent below yesterday’s S&P 500 closing level, had the biggest increase in ownership in the past seven days, adding 30,172 contracts to 171,780. March 1,250 puts, which have the largest open interest among all S&P 500 options, and April 1,200 puts were next.

“People are buying insurance,” Salvino, a specialist on the CBOE floor for Group One Trading, the primary market maker for VIX options, said in a phone interview yesterday. “What we’re seeing is simply the feeling that there’s a lot of bad things on the horizon, and they’re trying to price some of that in. There’s a certain level of fear.”

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