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It’s Getting Expensive to Be a Bear as Rules Pinch Options

More than just a casino for day traders, the options market is where institutions pay millions of dollars a day to hedge investments. Lately, amid a crackdown on risk-taking, they’ve been paying a little more.

Prices for Standard & Poor’s 500 Index put contracts, the options that act like insurance policies on stocks because they gain value when shares sink, have jumped this year to the highest levels on record relative to bullish calls. In one example, an option that appreciates if the market slides 10 percent by July has seen its cost shoot more than 120 percent above the corresponding bet on a rally. That’s twice the average spread since 2005.

In a bull market that hasn’t seen a 10 percent correction since 2011, it makes sense that prices are higher to protect equity holdings. But more may be at work. Rocky Fishman, an equity derivatives strategist at Deutsche Bank AG, says hedging costs are going up as dealers are crimped by regulations and self-imposed risk controls stemming from the financial crisis.

“The pricing of downside options is the most visible sign for this trend in periods when markets have not been very volatile,” Fishman said in a phone interview April 1. “It might be good business, but you can’t do it as much. The constraints are getting more aggressive.”

Liquidity Squeezes

Fishman is describing a concern similar to one that is raised in bond markets, where dealers have warned of liquidity squeezes due to restrictions prescribed by the Dodd-Frank Act. While banks have largely ceded their market-making role on equity exchanges to automated traders, they’re still among the biggest suppliers of stock hedges.

Divergences in price between bearish and bullish options can be seen all around the market. Puts expiring in July on the SPDR S&P 500 ETF Trust, the most popular U.S. exchange-traded fund, cost on average 105 percent more than calls this year, compared with 81 percent in 2014, Bloomberg data show.

Three-month protection against a 10 percent drop in the Powershares QQQ Trust, the largest fund tracking technology stocks, were priced 93 percent above bullish options as of April 10, Bloomberg data show. That spread has averaged 51 percent since 2009.

“Said simply, insurance costs more today than in the past since there are less folks carrying the insurance book,” Scott Maidel, an equity-derivatives portfolio manager in Seattle at Russell Investments, said in an interview April 7.

Too Expensive

The cost of six-month bearish options on the S&P 500 rose to 9.7 points higher than bullish ones on Feb. 4, the widest spread on record, according to Bloomberg data since 2005. That relationship was at 9.4 points last week.

Something’s making it more costly for managers who want to protect gains from a rally that has added $17 trillion to U.S. share values, according to Sean Heron, who helps oversee $30 billion for Glenmede Trust Co. The S&P 500 slid 0.5 percent to 2,092.44 at 4 p.m. in New York.

Because banks “are willing to sell less or put less on their books, risk protection has gotten a little expensive,” Heron, who manages options strategies for the firm, said by phone April 8. “People selling options right now may benefit from this and people buying options may reconsider because of prices.”

Not everyone is convinced shrinking dealer supply is the main reason bearish options have gotten more expensive. While measures of overall market turbulence such as the Chicago Board Options Exchange Volatility Index are hovering below their historical averages, equities have had a rougher ride in 2015.

The S&P 500, which never went more than three days without a gain in 2014, has twice fallen five straight times since the beginning of this year. Average daily S&P 500 moves have widened 50 percent from last year and shares tumbled 3 percent or more over four different stretches in the first quarter.

Nervousness Increases

Nervousness in the market is growing as investors try to figure out when the Federal Reserve will raise interest rates, according to Barclays Plc’s Maneesh Deshpande. That’s the primary reason for higher hedging costs, he said.

“Increased bank regulations have probably resulted in tighter risk limits,” Deshpande, head of equity derivatives strategies at Barclays, said by phone April 7. “So it appears logical that it is one of the reasons skew is high. However, based on data, that does not appear to be the only explanation.”

Shifts in market-making are part of the process of risk reassessment that was forced on banks by laws aimed at curbing excesses that led to the 2008 financial crisis, according to Karen Shaw Petrou, managing partner of Washington-based research firm Federal Financial Analytics Inc.

“Certainly everyone benefits from a safer financial system, but no one likes higher prices,” she said by phone April 9. “All of the biggest banks are spending enormous amounts of time optimizing capital and each choose to do so in different ways.”

Shoulder Tap

Getting a handle on how large a business options are for investment banks is an imprecise science because they don’t break out the results separately. Revenue from the derivatives businesses at the 10 largest banks globally made up about 38 percent of their equities revenue last year, according to a February report from Coalition Ltd., a London-based research firm.

The Fed examined how the biggest U.S. banks’ trading units, including equity derivatives, would handle a market shock in annual stress tests that were completed last month. The annual inspections are the cornerstone of the U.S. central bank’s efforts to prevent a repeat of the 2008 financial crisis and to gauge the ability of banks to withstand economic turmoil.

The tests, including the Comprehensive Capital Analysis Review, have constrained dealer supply at equity derivatives businesses, according to Krag “Buzz” Gregory, an equity derivatives strategist at Goldman Sachs Group Inc. Larger banks have become reluctant to hold short positions generated from selling hedges to clients, he said.

“The Federal Reserve checks all of your trading books on a given day and they say ‘what’s the risk ?’” Gregory said at a CBOE Holdings Inc. conference in Carlsbad, California, on March

6. “The last thing you want to do is sell $5 billion in downside puts the day they tap you on the shoulder. This is having an impact in pushing skew up.”

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