The Striking Price

Coping With the Rushing Bull

How to use upside calls to deal with investors chasing a suddenly torrid stock market.

By STEVEN M. SEARS

Saturday, July 16, 2016

Hold your nose. buy stocks. Buy calls. That’s basically what scores of institutional investors are doing as the Standard & Poor’s 500 index drives deeper into historical territory at the onset of earnings season.

This market-chasing coincides with a big shift that quietly kicked into high gear early last week. Amid a rise in rumors that central banks are preparing stimulus plans to jump-start tepid economies, investors have begun rotating away from low-volatility, high-quality stocks that have long provided shelter in a low-rate, low-growth world. They are now buying volatile, high-growth stocks.

It’s too early to tell if this is the start of a hard shift or just wishful positioning at the start of earnings season. The answer will become clearer over the following weeks as companies report earnings, enabling investors to determine if they made the right decision.

For now, these are facts: Steady and boring stocks are up sharply. Some investors are talking about a “low-vol bubble.” The phraseology seems more like trader talk to justify a sales pitch than reality. After all, the red-hot Select Sector Utility SPDR (ticker: XLU) is only up about 23% this year. Same for Verizon Communications (VZ). AT&T (T) is up about 28%.

A cynic might observe that the only real bubble relates to money-management fees, and the chronic inability of most institutional investors to beat their performance benchmarks.

After all, why pay two-and-20 to a hedge fund manager who buys stocks with dividend yields that exceed the 10-year Treasury? Now, many institutional investors are playing catch up with the stock market, traders and strategists say, which is driving money into stocks.

For example, last week investors bought about 80,000 Technology Select Sector SPDR ETF (XLK) July $45.50 calls that expire July 29. The expiration captures earnings for Apple (AAPL), Facebook (FB), and Alphabet (GOOGL). If the $45 ETF expires at $46.50, the calls, which were bought at prices up to 32 cents, are worth $1.

Upside calls are also active for Tesla Motors (TSLA) and Netflix (NFLX) in anticipation of the stocks rallying on earnings.

Buying stocks and buying calls is a lot like a legalized form of front-running. If you buy upside calls, and then buy stock to push prices toward the strikes, you win in two markets. Another game taking place is buying calls and starting rumors to pop the stock higher. This old bull-market trick was recently used on Harley Davidson (HOG).

In totality, the upside call demand is driving down the implied volatility of put prices. The fear premium that was just embedded in puts on the S&P 500 has largely disappeared. Now, there is a greed premium embedded in calls.

AT THESE ELEVATED market levels, with so much talk that there is no alternative for investors besides buying U.S. stocks, frustration is building with approaches that are anything but all in.

A high-net-worth broker recently confided that one of his clients just went nuclear. The fellow angrily chewed him out over his account’s performance. Though the account was diversified to reduce risk, and even though the client had been making money, the returns lagged the broad market. The client wanted to know why the advisor had not simply put all of his money into the S&P 500 SPDR (SPY) for the past seven years. True, this is only one story, but it shows how many people have been conditioned since the financial crisis that they should always buy the dip.

In short, sentiment is running as high in some quarters as the leading stock barometers. If you want to hedge away some of the risk, or position for a decline, many bearish put options are reasonably priced.

Reprinted by permission of Barron's Online, © 2016 Dow Jones & Company, Inc. All Rights Reserved Worldwide.

The views expressed in the above papers and articles are solely those of the author of the article, and do not necessarily reflect the views of OIC; the information presented is not intended to constitute investment advice or recommendations to purchase or sell securities of any company; and the information presented is based upon particular events that may or may not recur in the future.

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