Historical relationships between U.S. equity and options prices have come under increasing strain in the past week, with the record rally in the Standard & Poor’s 500 Index awakening demand among both speculators and hedgers.
The Chicago Board Options Exchange Volatility Index moved in the same direction as the S&P 500 for four straight days through April 29, including three advances and one drop. That’s the longest stretch of lockstep moves since February 2007, according to data compiled by Bloomberg. The indexes swing in the opposite direction about 80 percent of the time.
Options prices usually fall when equities gain because the optimism driving share prices reduces the demand for protection against losses. That relationship is wavering as traders become less certain about the direction of stocks after a four-year, 134 percent advance, according to Andrew Greeley, a senior managing director at Stamford, Connecticut-based Acorn Derivatives Management Corp. Dealers are charging bears more for insurance and bulls more to speculate on gains.
“Normally we would expect to see the VIX continue to slide lower as the S&P 500 (SPX) grinds up,” Greeley, who helps manage more than $450 million in volatility assets, said yesterday in an interview. “But as we get more extended in the recent trend and approach significant economic reports and central bank meetings, the VIX is capturing greater interest in out-of-the-money options, both calls and puts, as people bet on more stock gains as well as buy hedges.”
The VIX rose 1.7 percent from April 24 to April 29, while the S&P 500 gained 0.9 percent as speculation increased that central banks will add stimulus and companies beat earnings estimates. The options and stock benchmark gauges have moved together as traders awaited data on the American labor market and reports from the central banks of Europe and the U.S.
Policy makers at the Federal Reserve said yesterday they will maintain bond buying at a pace of $85 billion a month and are prepared to raise or lower the level of purchases as economic conditions evolve. Chairman Ben S. Bernanke is pressing on with his effort to boost employment as 11.7 million Americans remain jobless almost four years into the expansion.
The European Central Bank cut its benchmark rate to 0.5 percent from 0.75 percent today.
The U.S. Labor Department publishes its monthly jobs report tomorrow. Combined payrolls for companies and government agencies increased by 145,000 workers in April after rising 88,000 in March, according to a survey of economists by Bloomberg.
“Market highs induce a psychological inflection point,” Ed Tom, global head of equity derivatives strategy at Credit Suisse Group AG in New York, said yesterday in an interview. “As the market nears historic highs, investors simultaneously buy downside puts to protect gains and upside calls to lever into a continuing rally.”
The VIX jumped 7.2 percent to 14.49 yesterday for the biggest advance in two weeks as the normal relationship to stocks returned. The gauge of options prices on the S&P 500 has risen 28 percent since March 14, when it slid to its lowest level in six years. The S&P 500 slipped 0.9 percent to 1,582.70 yesterday. It reached an all-time high on April 30.
The U.S. volatility gauge fell 2.1 percent to 14.19 at 10:05 a.m. in New York today as the S&P 500 added 0.4 percent to 1,588.41.
Options traders have been increasing bullish bets on American equities. Outstanding bullish S&P 500 options rose 57 percent since the end of March to 4.17 million on April 29, data compiled by Bloomberg show. During that time, open interest for puts increased 39 percent to 6.75 million. That cut the ratio of puts to calls to 1.62-to-1, close to the lowest level since January.
Puts with an exercise level 10 percent below the S&P 500 cost 8.27 points more than calls 10 percent above, according to data on three-month contracts compiled by Bloomberg.
The last time the options and stocks moved in tandem for four days was in February 2007, according to data compiled by Bloomberg data. Of the 45 instances when they moved in lockstep since 1990, the S&P 500 rose 62 percent of the time in the next four weeks. The equity gauge has gained an average of 1.3 percent in those times, compared with a 0.6 percent gain in all four-week periods.
Volatility may return as investors brace for losses during the historically weak second quarter, according to Randall Warren, chief investment officer at Warren Financial Service. U.S. stocks have retreated between April and June in each of the past three years, with losses in the S&P 500 averaging 5.2 percent, data compiled by Bloomberg show.
“The VIX and the S&P 500 moving together tell a tale that even though the market is moving up, people are still looking for protection,” Warren, who oversees about $85 million including VIX options, said yesterday on the phone from Exton, Pennsylvania. “Protection is pretty cheap and maybe it’s time to pick up some for a rainy day. It’s well known that this time of year is tough for investors.”
Investors using exchange-traded funds have increased bets that stock swings will widen. Shares outstanding for the iPath S&P 500 VIX Short-Term Futures ETN climbed to an all-time high of 68.8 million on April 15, data compiled by Bloomberg show. The figure for the ProShares Ultra VIX Short-Term Futures reached a record 54.6 million shares on April 11. The two had the highest volume in the past 30 days among volatility-related securities.
There are more outstanding options betting on higher volatility than lower, with 4.82 million VIX calls versus 2.23 million puts as of April 29, data compiled by Bloomberg show. The ratio of calls-to-puts climbed to 3.10-to-1 on March 28, the highest level since February 2010.
The VIX moving with the S&P 500 is a sign that investors may be expecting further market gains, buying bullish options on the benchmark equity index (VIX) while at the same time using bearish contracts to hedge their increasing stock positions, according to Gene Lynch, an equity derivatives trader at Access Securities Inc. in Stamford, Connecticut.
“VIX levels can be driven by greed as much as by fear,” Lynch said yesterday in an interview. “The fear now seems to be driven more by being underinvested, which translates to buying calls and/or stocks with protective index puts.”
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