Options Highest Since 2007 Shows Gains Intact Amid HedgingJeff Kearns and Whitney Kisling
The end of the Federal Reserve’s Treasury repurchase program is prompting options traders to pay the most in four years for protection against stock declines, a signal that proved bullish in the past.
The cost of three-month put options to sell the Standard & Poor’s 500 Index is almost twice the price of calls to buy, the highest ratio since July 2007, according to data compiled by Bloomberg. The last 17 times that so-called skew rose as high, the benchmark gauge for American equities climbed a median 3.9 percent over three months, data compiled by Bloomberg show.
Traders are loading up on insurance in the options market on speculation policy makers will halt their program of quantitative easing in June. Similar purchases preceded gains in the past because they meant professional investors who use the contracts as hedges are buying stocks, said Pam Finelli, head of European equity derivatives research at Deutsche Bank AG.
“Risk management and portfolio protection is a huge theme in the market and it’s not unusual to see people expanding their equity allocation, but doing so with a hedge in place,” Finelli said in an interview from London. “The equity market goes up but the puts stay bid because there’s an underlying hedge that’s being put on at the same time. This has been a major trend.”
Sergi Martin Amoros, chief executive officer at Credit Andorra Asset Management in Andorra, added to equities following the March 11 earthquake in Japan, he said in a telephone interview on April 21. He’s also buying protection on the firm’s 4 billion euros ($5.8 billion) in investments.
“We made the most of the March sell-off to add to positions as equities had weakened,” he said. “There were good prices and we took the opportunity. We are buying puts and protection across the board. There are many open fronts, too many question marks.”
The S&P 500 fell 0.2 percent to 1,334.60 as of 9:42 a.m. in New York. It climbed 6.3 percent this year through April 21 as the U.S. unemployment rate unexpectedly dropped to a two-year low of 8.8 percent in March as companies created more jobs than forecast, the Labor Department said this month. The economy probably expanded at a 1.9 percent annual pace in the first quarter and will grow at an average rate of 3.1 percent though 2013, according to the average of estimates in a Bloomberg survey.
China’s decision to raise its reserve requirement for the biggest lenders to a record 20.5 percent to cool inflation sent the S&P 500 down 1.1 percent on April 18, the most in a month. Oil climbed for a third day to $112.29 in New York April 21, bringing its advance in the past year to 32 percent. Japan’s Nikkei-225 Stock Average plunged to a two-year low of 8,605.15 on March 15 after the earthquake and ensuing tsunami.
“Skew is really driven by net buying pressure of index puts and as that buying pressure increases, the skew gets steeper,” said Robert Whaley, a finance professor at Vanderbilt University in Nashville, Tennessee who designed the Chicago Board Options Exchange Volatility Index, or VIX. “There’s a significant effort going into managing the economy and people are more confident than they were, but there’s still that demand for protection.”
The S&P 500 rose 1.3 percent to 1,337.38 last week, the most in almost a month, after the biggest U.S. companies reported better-than-estimated profits. Of the 121 S&P 500 constituents that have reported earnings since April 11, 82 percent have beaten analysts’ per-share earnings estimates, according to data compiled by Bloomberg.
The gauge climbed 1.4 percent on April 20 after Santa Clara, California-based Intel Corp., the world’s biggest chipmaker, forecast second-quarter sales above analysts’ estimates. Cupertino, California-based Apple Inc. reported profit that almost doubled amid rising demand for the iPhone. United Technologies Corp., the Hartford, Connecticut-based maker of Carrier air conditioners and Pratt & Whitney jet engines, said 2011 sales will be at the high end of its forecast.
“Earnings are still good,” said Mark Bronzo, who helps manage $25.5 billion at Security Global Investors in Irvington, New York. “With China raising rates, higher fuel prices and the tragedy in Japan, people have gotten concerned that with all of these disruptions earnings could be impacted as expectations were high. The worst fear has not been realized.”
Implied volatility, the key gauge of option prices, for S&P 500 puts 10 percent below the index was 21.20, 1.86 times the level for the equivalent calls, on April 20. That ratio is in the 83rd percentile for the past five years, the data show. In the 17 occurrences of skew exceeding 1.86 before this year, the S&P 500 gained after all but two with a median increase of 3.9 percent, data compiled by Bloomberg show. The biggest gain was 9.2 percent in three months after the skew reached 2.03 in July
The VIX, which measures the cost of S&P 500 options with a 30-day maturity, is down by half from this year’s peak of 29.40 on March 16 to 14.69 last week, the lowest since June 2007. The three-month VIX is down 32 percent from the peak to 18.35.
The skew ratio reached 2.32, its highest level of the past five years, on April 13, 2007. Six months later, the S&P 500 peaked at 1,565.15 then plunged 57 percent over the next 17 months, wiping out $11 trillion in U.S. equity value. The lowest skew during the period was 1.16 on Nov. 20, 2008, the same day that the VIX soared to a record 80.86 following the bankruptcy of New York-based securities firm Lehman Brothers Holdings Inc.
Adding to Hedges
Traders are adding to hedges after being caught off guard by Japan’s earthquake and tsunami, said Mandy Xu, an equity derivatives strategist at Credit Suisse Group AG in New York. S&P 500 skew was 1.62, the lowest in two months, on March 10, the day before stocks plunged and volatility soared worldwide. The VIX and its European counterpart, the VStoxx Index, jumped to the highest levels since July, while Japan’s Nikkei Stock Average Volatility Index surged to a two-year high of 69.88.
“While some macro risks have subsided in recent weeks, such as Japan and the Middle East, and that has driven implied volatility lower, other option signals suggest investors remain nervous and continue to hedge,” Xu said. “This is why skew remains elevated despite the lower VIX.”
The S&P 500 has risen 28 percent since Aug. 26, the day before Fed Chairman Ben S. Bernanke said in Jackson Hole, Wyoming, that he was willing to do “everything in his power” to stimulate growth. In November, the central bank pledged to complete $600 billion in bond purchases by the end of June.
“We’re definitely in a bull market,” said Randall Warren, chief investment officer at Warren Financial Services & Associates Inc., which trades VIX options and manages $65 million in Exton, Pennsylvania. “People are worried about a lot of things, from geopolitical risk to earthquakes in Japan to the downgrading of U.S. debt, and there are a million things to be worried about. But the market is climbing that wall of worry.”
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