Options Report: Fund Managers Are Shorting Volatility
By STEVEN M. SEARS
NEW YORK -- Unsure of which way the stock market is headed and plagued by expensive options contracts, many hedge fund managers are finding creative ways to exploit volatility.
One trade that's emerging finds fund managers selling equity call options against long stock positions to capitalize on the high volatility in the derivatives market. And because it also increases the return on the stock investment, the trade has the salubrious effect of reducing the effects of a cantankerous equity market.
The strategy, known as an an "overwrite," indicates that money managers think volatility, a key part of an option's prices, is poised to decline from unusually high levels. These managers are so certain that their volatility forecasts are accurate that they have in some cases committed themselves to sell hundreds of thousands of shares of stock.
In Becton, Dickinson & Co., for example, a fund manager sold 4,000 June 30 calls when the volatility of the contracts was around 57, a number that is about 20-points higher than the January average, a trader said.
If the volatility in Becton's options declines or if Becton's stock price does not exceed 30 before the options expire in June, the short calls can be repurchased below their initial sale price. The passage of time also helps the money managers. Because options contracts ultimately expire, puts and calls lose a little bit of value each day - a phenomenon called "time decay."
But if Becton's stock exceeds 30, the money manager is obligated to 400,000 shares. Yet he will actually net 31 or 31 1/16 a share - an amount that is equal to the call's strike price plus the amount received for selling the calls.
With the stock down 1/4 at 25 3/4, Becton's June 30 calls gained 1/8 to 1 on Philadelphia Stock Exchange volume of 4,119 contracts, compared with composite open interest of 1,052 contracts.
It's possible that Becton's stock will not make much of a move before expiration. When PaineWebber lowered the company's investment rating last Thursday to neutral from attractive, the investment bank said it appeared that Becton's growth would slow in the third quarter and beyond.
Becton's "vols are at the high end of the range," said Paul Foster, 1010WallStreet.com's options strategist. "Volatility should be sold before it goes back down."
The CBOE's Market Volatility Index, or VIX, was recently at 29.35, up 2.29. Although the VIX is only about five points higher than usual, the index is still far below its 18-month high of 41.52 set April 14.
Foster said selling volatility when it is at a high level has continually proven to be a smart trade. "Look at Sun Microsystems, America Online, Microsoft," he said. "A lot of stocks had high volatility over the last three of four weeks. Volatility has not started to move lower as the risk of owning the stocks became more apparent." snip....
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