Dead Zone for Stocks Breathes Life Into Options Bull-Bear Trade

  • The purchase of skew returned the most since 2014 in August
  • S&P 500 hasn’t moved more than 1 percent in 39 sessions

If you try hard enough, you can still make money trading volatility in the calmest U.S. stock market in six decades.

One tactic, skew buying, is paying off for speculators who take a position on price discrepancies between bullish and bearish options on the S&P 500 Index. Traders who bet investor appetite for equity protection would remain brisk even as the CBOE Volatility Index slid to a two-year low are making money after bearish puts rose versus bullish calls at the fastest rate since 2014.

Such a move is unusual in a market where the VIX spent most of the month more than 25 percent below its one-year average, according to Macro Risk Advisors. The benchmark’s sharp rally after the Brexit selloff and subsequent monthlong sideways move created the ideal conditions for the trade, something that previously happened in late 2014, MRA said.

“S&P skew had flattened out during the rally back from the Brexit lows,” Pravit Chintawongvanich, head derivatives strategist at MRA, wrote in a client note on Thursday. “As the market stopped rallying, skew steepened back out to normal levels. Surprisingly, owning skew actually made money in August.”

By MRA’s logic, after stocks rally, the demand for protection eases and skew settles down, creating room for upside in the options trade if investors start to get antsy again. That’s what happened in late 2014 when the equity benchmark recovered from a six-month low before settling into a monthlong malaise, they said. The same conditions arose this year as stocks rebounded in July from a multi-month low after the Brexit vote only to spend August going nowhere.

Traders have been seeking returns wherever they can in a market that hasn’t seen a 1 percent move in either direction for 39 days, the longest such streak in more than two years. The spot price for VIX contracts has also stagnated, staying below 15 for the past 42 sessions. 

But the cost of protecting against losses has been rising relative to bets for further gains. Investors have been wary of getting overextended with the U.S. presidential election looming and amid continued uncertainty over the Federal Reserve’s timetable for an interest rate hike.

It’s likely the fear gauge itself will start to show heightened investor anxiety given the seasonality of the stock market, according to Russ Koesterich of BlackRock Inc. Over the past quarter century, the VIX has averaged over 22 in September, the highest of any month. The index slipped 9.2 percent to 12.24 in New York.

A VIX spike would be a bearish signal for stocks, as the measure moves in the opposite direction of the S&P 500 about 80 percent of the time. The resulting disruption to the index’s grind higher would threaten to derail the present environment that’s so conducive to buying skew as investors pay more for protection against losses. The measure is already back within a point of its one-year average.

Koesterich says the Fed’s upcoming rate decisions have the potential to derail the S&P 500 itself, especially if the central bank defies the timeline priced in by markets.

“To the extent the Fed tightens a bit faster than the languid pace discounted by markets, that would likely be a catalyst for some mean reversion in volatility,” Koesterich, head of asset allocation for BlackRock’s Global Allocation Fund, wrote in a blog post on Thursday. “Historically, the S&P 500 has declined by around 1.3 percent for each one point rise in the VIX. Should the VIX over-correct and rise back towards the highs hit in January, investors could be looking at something more nasty.”

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