Calm Before the Storm?
Low volatility often precedes market downturn
By Erin E. Arvedlund / January 28th, 2002
If anything can go wrong for options these days, it will. Painfully, investors are learning how different pieces of an option's price can erode at the same time. Volatility, the key to option prices, is dribbling lower; interest rates, a little-remembered factor, have fallen to historic lows; and the underlying equities are getting spanked.
What can investors do to make money in such an environment? It's possible to be both bearish on the market and bullish on option volatility bouncing back, particularly in individual stocks. The widely watched Chicago Board Options Exchange Volatility Index, or VIX, is creeping down into the low 20s; option buyers are in retreat, and complacency is setting in -- a situation often leading to a market explosion, usually downward.
With premiums so low, now isn't the best time to sell call options on stocks in your portfolio, a popular strategy known as covered calls. But if you're determined to do so, stick to selling calls on relatively expensive, high-multiple stocks, and ideally during rallies, says Kyle Rosen, founder of Rosen Capital Management, a hedge fund in Santa Monica, California. "That's one of the few places to make money right now, possibly for the next six months."
Why are price-earnings multiples contracting? Blame Enron. "People don't trust balance sheets anymore, so investors are asking, 'Why pay an outrageous premium for earnings?' " If a Big Five accounting firm signed off on questionable numbers so that Enron would hit the Street's numbers, maybe the bean counters were doing the same favor for other companies. "In many ways, Enron is worse than Long-Term Capital Management," Rosen adds. "At least in that case Wall Street could point to a rogue hedge fund. Enron calls into question investors' confidence in how stock multiples are calculated."
For that reason, some strategists recommend seeking companies where profit margins are expanding. Overall, the Standard & Poor's 500's profit margin has fallen to the 1990-1991 recession low of 3.2%, a dramatic decline from the peak of 7.4% in Dec 2000. Since Dec 2000, the S&P 500's profitability has fallen to 1.5% from 6.5%, the lowest recorded between the years 1977 and 2001, according to data from Credit Suisse First Boston.
(Here's another reference to VIX in the 20s.)
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