Dormant VIX Belies Options Bonanza for Bets on Earnings Swings

Updated on
  • U.S. companies with active options have seen high volatility
  • S&P 500 pushed aside geopolitical turmoil to reach records

Below the surface of the calmest stock market in two years lurks some of the highest earnings-related volatility of the past few decades.

Since quarterly reports began last week, an options strategy that profits from a large stock move in either direction has seen returns that are more than 10 times higher than the 20-year average, according to data compiled by Goldman Sachs Group Inc.

That the trade has been working is a reminder that while investors may have gotten over geopolitical anxiety, they’re still on edge about earnings, the primary driver of stock prices. The S&P 500 Index just finished its longest stretch without a record high outside a bear market since 1985 -- a period that coincides with a streak of profit declines that is about to reach five quarters.

“The macro events that have been driving the market for pretty much the whole year are now way in the secondary, with earnings season upon us,” Steve Claussen, chief investment strategist at OptionsHouse LLC, the Chicago-based online brokerage, said by phone. “People are starting to look at stock-specific news, now that some of the macro fear has been taken out.”

U.S. equities are falling out of rank with one another and responding to their own news more than at any point in three years, according to a measure of implied correlation. The drop comes as the S&P 500 sits near a record high amid an increase in risk appetites and comparatively attractive yields for stocks.

Two inputs are driving the trade’s profitability: the magnitude of post-earnings moves and the overall placidity of stocks, which lowers the price of options as a class. The CBOE Volatility Index, derived from options and reflecting stress levels in the market, has averaged 12.8 since Alcoa Inc. reported results on July 11, compared with 15.7 in the three years prior.

On Wednesday, the VIX closed at 11.77, the lowest since August 2014. The so-called fear gauge slid 5 percent to 12.11 at 1:38 p.m.

“The market’s incredible resilience has created this lower implied volatility environment,” said Claussen. “If the macro market isn’t contributing to the nervousness of earnings season, then individual stocks have less of a hurdle to move post-earnings. And the focus now is on stock-specific results.”

Betting on big price swings leading up to and following quarterly reports has proven successful, according to Goldman Sachs.

Investors who have bought out-of-the-money calls and puts on the same stock, with the same maturities, five days ahead of earnings have seen returns of 24 percent if they closed the trade the day after results, the firm wrote in a July 20 client note. The strategy, known as a strangle, had previously averaged a 2 percent return over 20 years, the data show.

The opportunity may be short-lived with the U.S. equity market facing imminent event risk, which will soon ratchet up investor nervousness once again, according to Mark Kepner of Themis Trading LLC.

“We’re getting back to looking at what directly matters to us, which right now is earnings,” Kepner, a managing director and equity trader at Themis Trading in Chatham, New Jersey, said by phone. “But the VIX won’t stay anywhere near this low, with what we have coming in terms of more earnings reports and the presidential election.”

(Updates with Friday’s VIX trading in seventh paragraph.)
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