A Falling Gauge of Volatility May Be Bad News for Stocks
By PATRICK McGEEHAN
New York Times, Sunday, June 10, 2001
nytimes.com
Professional options traders, like sailors and fishermen, are always watching for a break in the weather. The barometers they follow closely are gauges of volatility, or fluctuations in the prices of stocks and options.
Lately, the market has been unseasonably quiet. One key measure of volatility, an index calculated by the Chicago Board Options Exchange and known as the VIX (its ticker symbol), has dropped sharply in recent weeks as it approaches its usual mid- summer lows.
On Tuesday, the VIX closed at 21.22, the lowest since mid-September and down about half from its high for the last year of about 42. (It closed at 21.41 on Friday.) In each of the last three years, the VIX hit its lowest point, somewhere between 17 and 20, from July through September.
Options traders are wondering whether the usual summer slowdown is just coming early this year or if something else is afoot. Either way, they say, volatility this low does not bode well for the overall stock market.
"It's supposed to be an indication of sentiment," said Michael Schwartz, chief options strategist at CIBC Oppenheimer. "The higher the volatility, the higher the fear or expectations. Right now, it's really reflecting low expectations."
There is a sunnier interpretation — that the markets are stable or that investors have grown complacent after two traumatic years of boom and bust. But the pros on Wall Street are not so charitable, because they crave action and usually profit from it.
The last time the VIX dipped below 25 was in the first week of February. In the next two months, the Standard & Poor's 500-stock index shed about 250 points, or about 18 percent of its value. Then, with the VIX pushing 40, the S.& P. 500 rallied more than 200 points by late May.
Volatility indexes are of most interest to options traders because volatility directly affects option prices. A stock option is essentially a bet that a stock will reach a certain price within a set period. Wild price swings improve the chances of getting there.
The pros who make markets in options are vulnerable to volatility, just as yachtsmen are at the mercy of the wind and waves. When volatility dies down, the value of options can sink.
"The theory on their part is that volatility is like an elastic band," Mr. Schwartz said. "When it stretches, they'll sell it. When it contracts, they'll try to buy it back."
Traders tend to believe that markets are self-correcting, so when volatility is low, they bet on its rise by buying options. When it is high, they bet on its fall by selling options.
But traders are not aggressively buying options now, Mr. Schwartz said, because they fear that the low level of volatility will last through the summer. Because time truly is money to the holders of options, which can expire worthless, the livelihoods of options traders depend on their ability to time the swings in volatility.
The VIX speaks to other investors in a different voice. Some stockbrokers monitor it for signals of short-term, even intraday, opportunities to buy stocks. One Merrill Lynch broker in New York said he considered a relatively high VIX to be a bullish indicator.
"When it's high, you buy," he said. "Buy anything, stocks, options — just buy."
What does he do when the VIX is low, as it is now? Not much. He said he did not consider low volatility a trustworthy signal to sell stocks.
So how can investors take advantage of what may be a long, slow summer? Mr. Schwartz recommends buying shares of the S.& P. 500 Depository Trust, a market index fund that trades on the American Stock Exchange, and to insure against a decline by simultaneously buying long-term put options on the S.& P. 500.
A put option gives the owner the right, but not the obligation, to sell an underlying security at a set price on or before its expiration date. For the combination trade to be profitable, the index fund shares would have to rise by more than the cost of the put options, or about 7 percent.
Last week, Mr. Schwartz said, an investor could have bought 100 shares of the fund and a put option on the index with an exercise price of $130 that would not expire until December 2003. Together, they would have cost $14,053, before commissions. Losses would have been limited to $701 over 30 months and the potential gains would be unlimited.
If all that sounds too risky or complex, you might consider spending the summer sailing or fishing. |
