The Striking Price

Options Volatility Sleeps as Risks Increase

Volatility has all but disappeared from stocks this summer. Is this unnatural calm a prelude to a storm? And, what’s behind a dearth of hedging.

By STEVEN M. SEARS

Saturday, August 27, 2016

Equity volatility, realized and implied, is at extremely low levels, especially with major economic reports, possible interest-rate hikes, and a contentious presidential election on the horizon. Greater volatility would confirm what many investors believe: that the U.S. stock market deserves to trade at a significant risk premium. Yet the market’s grinding advance persists against a backdrop of ultralow interest rates.

Perhaps sentiment will one day trump fundamentals, but for now the Standard & Poor’s 500 index’s realized volatility is around 5%. Implied volatility, which expresses the anticipated movement of securities at some future date, is near similarly record lows, at about 8%. These quiet levels indicate that the options market expects the stock market to move by no more than 0.5% each day, no matter who wins the election, or whether the Federal Reserve increases interest rates or not.

BASED ON THE OPTIONS MARKET, which some call the stock market’s central nervous system, the prospect of a Donald Trump or Hillary Clinton presidency poses no risk to the stock market’s health. Options on the S&P 500 index that expire in one to three months indicate no hedging before or around the Nov. 8 presidential election, says Krag “Buzz” Gregory, a Goldman Sachs’ derivatives strategist.

The stock market tends to perform well around presidential elections. S&P 500 returns typically have been positive one and three months before and after voters go to the polls. Volatility also has been muted, although rarely this muted. Gregory says the median level of S&P 500 one-month realized volatility has been below 12 for one- to three-months before and after the election.

The data suggest that investors are waiting, and can afford to wait, to buy strategic portfolio hedges. Gregory’s research also helps explain why so many investors are buying upside calls on the CBOE Volatility Index, rather than hedging their portfolios with traditional index options.

The S&P 500, unlike VIX, has “strike risk.” An at-the-money index put might suddenly lose its value if the market advances in reaction to investor flows and news events. VIX calls don’t have the same risk; a quick drop in the stock market can, and often does, send VIX sharply higher, creating a chance to trade volatility moves. That’s why there is always a market for VIX calls that pay off if VIX hits 20.

EVEN THOUGH it is becoming popular on Wall Street to call portfolio hedging inexpensive, at least as it is measured by realized and implied volatility, hedging has actually been one of the Street’s most expensive trades for many years. The stock market has primarily advanced since 2009, rendering many hedges useless.

“A surefire way to get a laugh out of equity portfolio managers these days is to recommend hedges,” says Jim Strugger, MKM Partners’ derivatives strategist.

One day—and it might arrive later this year, or in 2017—all of this will change. But first the Federal Reserve will need to modify its easy-money policies and raise interest rates. While knowing that this eventually will happen, even sophisticated investors are unclear as to whether it pays to anticipate the policy shift, or react after it has occurred. After all, if the election of a polarizing, profoundly disliked presidential candidate is deemed to be a riskless event for the market, is a quarter-of-a-percentage-point rate hike really a big deal?

That is more than a coy point; it is a multibillion-dollar question.

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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