Stock Volatility Looms as Fed Bond Buying Ends: Options

The trajectory of the U.S. stock market is about to get bumpier, according to one measure in the options market.

Investors are bidding up contracts that protect against losses in the Standard & Poor’s 500 Index in the next three months, driving the price to near the highest level in 19 months compared with contracts expiring in a month. The difference in implied volatility shows traders are hedging for risks that may be months away while expressing less concern over the present.

With markets calm for now, investors are buying longer-dated options as the Federal Reserve prepares to conclude its bond buying program by October and attention shifts to when interest rates will be raised. The S&P 500 hasn’t posted a four-day streak of losses in all of 2014 and the last time it fell more than 10 percent was three years ago.

“Everyone knows how long this bull run has been, and with every day that passes, we’re one day closer to a 20 percent correction,” JC O’Hara, the New York-based chief market technician at FBN Securities Inc, said by phone. “Some smart money is slowly beginning to accumulate downside protection.”

The bull market has lasted 2,009 days since starting in March 2009, making it the fourth-longest since 1928, according to a report from Bespoke Investment Group LLC.

VIX Climbs

The S&P 500 added 0.2 percent last week to 2,007.71 in a fifth week of gains, the longest rising streak since last November. The Chicago Board Options Exchange Volatility Index, as the gauge of S&P 500 options prices is known, added 0.9 percent to 12.09.

The S&P 500 fell 0.3 percent to 2,001.54 at 4 p.m. in New York. The VIX jumped 4.7 percent to 12.66, the highest level since Aug. 15.

Implied volatility for three-month contracts on the S&P 500 is 11.3, compared with 9.2 for options that expire in 30 days, according to data compiled by Bloomberg. The gap reached 2.4 points Aug. 29, the most since January 2013.

Six-month contracts on the equity index are 3.7 points more expensive than one-month ones. The spread reached 4.1 Aug. 29, the most in 19 months.

“People are starting to realize that over the long run, a lot of things need to happen for implied volatility to remain as low as it is right now,” Bill Merz, a strategist on the derivatives and structured products team at U.S. Bank Wealth Management, said by phone. The firm oversees $124 billion.

Bond Buying

Fed policy makers tapered monthly bond-buying in July to $25 billion in their sixth consecutive reduction, staying on pace to end the stimulus program in October. The Fed’s next meeting concludes Sept. 17.

In a speech to central bankers in Jackson Hole, Wyoming last month, Fed Chair Janet Yellen emphasized the need for flexibility in determining when to increase key borrowing costs. If progress “continues to be more rapid than anticipated,” a rate rise could come sooner than currently expected and further increases could be more rapid, she said. Conversely, if the Fed’s goals of full employment and stable prices remain elusive, policy would be more accommodative.

“The market has been conditioned to dovishness,” Peter Cecchini, the New York-based chief strategist and global head of macro equity derivatives at Cantor Fitzgerald LP, said in an interview. “The irony going into 2015 could be that the macro data continues to improve, but U.S. markets take a breather as they digest a sooner-than-expected tightening.”

Payrolls Data

American employers hired fewer workers than forecast in August, while the jobless rate dropped because people left the workforce, bolstering arguments for Fed officials who want to be more deliberate in removing monetary stimulus. The 142,000 advance in nonfarm payrolls was the smallest this year, figures from the Labor Department showed last week.

Prospects for continued strength in the economy suggest stocks will keep heading higher, even if rates are raised, according to Karyn Cavanaugh of Voya Investment Management LLC. U.S. gross domestic product is projected to expand 3 percent in 2015, according to economists’ estimate compiled by Bloomberg. That would be the fastest growth in a decade.

“We’re looking for a U.S. rate cut sooner rather than later,” Cavanaugh, a senior market strategist at New York-based Voya, which oversees about $215 billion, said by phone. “That’s not necessarily a bad thing because it’s based on good data. We may see some increased volatility but I think overall getting back to normal is a good thing for the market.”

Fed officials in June forecast that the benchmark rate would rise some time next year. It has been held near zero since December 2008 as the Fed battled the deepest recession since the Great Depression and later sought to keep the recovery going.

“We’re in the mother of all accommodative cycles,” Jim Paulsen, who helps oversee $357 billion as chief investment strategist at San Francisco-based Wells Capital Management Inc., said by phone. “To think we’re going to turn that accommodative boat without any ripples in the stock market is a little unrealistic.”

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