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Bears Retreat in Options Market as Put Premium Declines to 20-Month Low
By Jeff Kearns, Whitney Kisling and Cecile Vannucci – Aug 10, 2011 10:33 PM GMT+0200
The biggest plunge in stocks in more than two years is prompting U.S. options traders to pay the lowest prices for bearish contracts compared with bullish ones since December 2009.
The premium investors paid for three-month puts to sell the Standard & Poor’s 500 Index versus call options to buy dropped to 50 percent yesterday from 84 percent on July 19, a period when as much as $2.5 trillion was erased from the value of global equities. The S&P 500 has rallied 6.3 percent on average in the month after the gap narrowed more than 10 percent, according to data compiled by Bloomberg since 2005.
Speculation that record profits and the lowest valuations in two years will limit losses is reducing the options price relationship known as skew. The benchmark gauge for U.S. equities climbed 4.7 percent yesterday, rebounding from a 6.7 percent decline on Aug. 8 after S&P cut the U.S. government’s AAA credit rating to AA+. U.S. equity strategists forecast the index will gain 18 percent by January.
“The contrarian would say the more panic and blood in streets, the fewer people left to sell and therefore the closer you are to a bottom,” Bob Doll, chief equity strategist at New York-based BlackRock Inc., which manages $3.66 trillion, said in a telephone interview yesterday. “When you see the volume and the skewness that we’ve seen, I could see it as a bullish sign.”
The S&P 500 has declined 13 percent since July 22 on speculation the world’s largest economy is slowing and European policy makers will fail to keep their debt crisis from spreading. The losses accelerated when S&P reduced its credit rating, conflicting with Moody’s Investors Service and Fitch Ratings, which reaffirmed their highest rating on Treasuries. Trading volume was a 2011 record 18 billion shares in the U.S. yesterday, when the S&P 500 rallied 4.7 percent.
The S&P 500 declined 4.4 percent to 1,120.76 as of 4 a.m. in New York, erasing almost all of yesterday’s 4.7 percent advance that was the biggest jump since March 2009.
In options, three-month S&P 500 puts to sell if the index declines 10 percent have an implied volatility of 35.42 versus 23.68 for the equivalent calls. A month ago, volatility on the puts was 21.21 and 12.01 on the calls. Volatility is the key gauge of option prices. With those puts costing 67 percent more than they did a month ago, traders are paying a higher price to shield stocks from losses.
“The fear has been priced in, and people are taking their hedges off,” Sean Heron, who manages options strategies at Glenmede Trust Co., said in a telephone interview yesterday. The Philadelphia-based firm oversees $20 billion. “People are recognizing that valuations are compelling and they’d rather sell their puts because this too shall pass.”
While the price of bearish options is falling relative to bullish ones, the VIX, as the Chicago Board Options Exchange Volatility Index is known, shows that options dealers are still charging some of the highest prices in a year for hedges.
The VIX soared 50 percent to 48 on Aug. 8 for the biggest gain since February 2007. The gauge of S&P 500 options plunged 27 percent yesterday to 35.06 for the second-largest drop ever, after the Federal Reserve said it had tools to revive economic growth. The VIX has averaged 20.35 over its 21-year history.
The decline in the S&P 500 sent its price-earnings ratio down 17 percent since July 22, the biggest decrease since July 2010. The index trades at 12.8 times profit for the past year, the lowest valuation since the bull market began in March 2009. The average multiple since 1954 is 16.4, according to data compiled by Bloomberg.
S&P 500 earnings are beating analyst estimates by 5.1 percent, increasing at an average 17 percent rate for the quarter ending June 30. Wall Street firms project profits will climb 18 percent this year to $99.42 a share, the highest level on record, according to data compiled by S&P and Bloomberg.
Chief strategists at 13 banks from Barclays Plc to UBS AG see the benchmark measure of American equity surging 18 percent through Dec. 31 to 1,389, the average estimate in a Bloomberg survey. A year ago, strategists also remained bullish after a 14 percent drop, and proved prescient as the S&P 500 rallied 20 percent from its August low.
“From a valuations and earnings perspective, there’s tremendous opportunity in the market today,” Matthew Rubin, the New York-based director of investment strategy at Neuberger Berman Group LLC, said in a telephone interview yesterday. The firm manages more than $198 billion in assets. “If you’re able to look through this and weather the storm, you can find great companies.”
To contact the reporters on this story: Jeff Kearns in New York at firstname.lastname@example.org; Whitney Kisling in New York at email@example.com; Cecile Vannucci in Amsterdam at firstname.lastname@example.org