S&P 500 Options Looking Like a Steal Before Referendum on Brexit

  • 30-day implied volatility on index lower than 1-year average
  • VIX has declined 12 percent since reaching four-month high

What Investors Are Saying About the Possibility of Brexit

The U.S. options market is underpricing the risk of British secession from the European Union, according to a New York-based firm that arranges volatility trades.

Implied volatility for S&P 500 Index at-the-money contracts expiring in 30 days sits at 15.1 percent, a price that is actually below the average level of the past year, according to data compiled by Bloomberg. Placidity can also be seen in the benchmark index’s fear gauge, the options-derived benchmark which has fallen 12 percent in the last week after reaching a four-month high.

With the potentially market-moving referendum set for Thursday, strategists at Macro Risk Advisors say investors should be bracing for bigger price swings. A vote to leave the EU would unleash turmoil across global markets, the type of outcome for which investors have historically been unprepared, according to MRA.

“If you’re looking to hedge with the pound, people already beat you to it,” Dean Curnutt, chief executive officer at Macro Risk Advisors, said in a phone interview. “But when you start to get away from the U.K. and Europe, there’s an opportunity to buy options and insurance on things like the S&P that didn’t reflect the potential for spillover. In the past, the market hasn’t shown a very strong ability to understand risk and price outcomes based on politics.”

One cost-effective way for an investor to protect against a market decline would be to use three-month put spreads, strategies designed to hedge against a short-term drop in an asset, according to MRA. Such protection now costs roughly the same as it did a year ago, a comparatively quiet period for markets, the firm said.

Viewed as the more likely outcome as recently as last week, the Brexit option has seen its popularity wane. A poll published over the weekend showed 45 percent of voters supported remaining in the union, while 42 percent favored leaving. Odds at betting shops also suggested dwindling support for the secession following Thursday’s murder of U.K. lawmaker Jo Cox, who backed staying in the EU.

Still, anything with a probability of 30 percent or more “ceases to be a tail risk and must be confronted as a realistic potential outcome,” MRA wrote in a June 9 client note.

As the likelihood of a Brexit has decreased, so has the CBOE Volatility Index, which slipped 5.4 percent on Monday, the most in four weeks. The gauge of price swings has fallen in five of the last six sessions. It added 0.3 percent to 18.42 at 10:05 a.m. in New York. The volatility index generally trades inversely to the S&P 500.

Resilience has been a guiding principle this year in the U.S. stock market, where investors have been unwilling to embrace bearishness. With a 0.6 percent gain on Monday, the S&P 500 sits just 2.2 percent from an all-time record even after two straight weeks of declines. The benchmark gauge bounced back earlier this year after getting off to its worst-ever start, erasing an 11 percent loss in less than two months.

While the recent spot price may indicate less worry heading into the Brexit referendum, that hasn’t stopped investors from piling into VIX-linked products. Trading in five of the most popular VIX instruments surged to more than 4 percent of total volume on U.S. exchanges, a level that before last week had never been reached, according to data compiled by Sundial Capital Research Inc. and Bloomberg.

Meanwhile, as of June 7, hedge funds and large speculators held more short bets on VIX futures than at any time since 2013, according to data from the U.S. Commodity Futures Trading Commission. Less than a quarter of these short positions were covered during last week’s 14 percent VIX increase, making calls on the gauge an “excellent hedge” for a long portfolio, according to Schaeffer’s Investment Research Inc.

“Short-term VIX calls remain an attractive portfolio hedge in the event that market participants react unfavorably,” Todd Salamone, senior vice president at Cincinnati-based Schaeffer’s Investment Research, wrote in a client note on Monday. “We see short volatility speculators as particularly vulnerable to a negative surprise.”

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