interactive.wsj.com
May 25, 1998
The Smell of Fear
Tracking it through implied volatilities
By Michael Santoli
Like wild animals, the best options traders are said to be
able to smell fear and then exploit it. Luckily for the rest,
there are statistics that capture that odor and -- at least as
importantly -- detect its absence.
The prices of stock-index options, as measured by implied
volatility, contain plenty of information about the
fearfulness of investors. Rising fear usually causes them to
pay up lavishly for the protection contained in the options.
Sliding volatilities indicate a "what-me-worry?" madness
that is viewed as a signal of an imminent drop in the stock
market.
Plenty has been said, here and elsewhere, about how
rock-bottom volatilities, or vols in market parlance, early
this year were flashing signs of a steep correction that
never arrived. But the derivatives hounds at Salomon
Smith Barney last week told clients that on a more modest
scale, receding vols have indeed forecast a selloff the
following week. Using the VIX, the index that tracks the
vols of Standard & Poor's 100 index options, Salomon's
Leon Gross and his team show that each time the index has
dipped below 20% as the market was rising, the S&P 500
soon stumbled. In the most recent instance, the VIX broke
below 20% in the last week of March and in the first week
in April the S&P lost 2%.
The VIX last week was
flirting again with the 20%
level, though no firm sell
signal was reached.
Nonetheless, Salomon was
recommending last week that
it was a good time to buy
some insurance to shield
stock portfolios from a
possible downturn -- the firm
is, after all, in the business of
selling the stuff.
The simplest insurance policy would be the purchase of
S&P-500 index puts, which Salomon points out have come
down in price as vols have retreated. But wait. The
Salomon report itself notes that even at these prices, S&P
puts are fetching a "big premium" to historical volatilities,
meaning that even if fear is declining it's higher than the
recent past would suggest. Calls, meantime, are
persistently cheap.
This is why guys like Max Ansbacher have made a killing
recently. Ansbacher's hedge fund, Ansbacher Investment
Management, exclusively sells out-of-the-money S&P 500
options according to a system that determines which ones
are most overvalued. Of late, that has meant he has been
almost entirely short index puts, which in this fairly robust
market have tended to head toward zero, leaving
Ansbacher with plenty of free premium left in his pockets.
Thus his returns of 95% in 1997 and 27% this year through
April, in a perfect climate for being short puts.
Yet the Salomon view and Ansbacher's success are not
necessarily at odds: There can be a trading-range market
such as this one with inflated put prices, along with rolling,
sharp corrections born of momentary complacency. And
because Salomon's advice is focused on near-the-money
options and Ansbacher dwells well out of the money, both
can co-exist profitably, if the market cooperates.
In fact, there is a way around the priciness of S&P puts for
hedgers: Salomon suggests that options on sector indexes
with high correlations to the S&P 500 are cheaper and can
be used as a substitute. Specific recommendations include
buying puts, or put spreads, on the Philadelphia Stock
Exchange Bank Index, the Nasdaq 100 and the American
Stock Exchange Pharmeceuticals Index, whose correlations
to the S&P each run near 70%.
Speaking of other indexes, trading in Nasdaq 100 options
was delayed an hour Friday morning when the index
inexplicably showed an instant 20-point loss. No, the
government hadn't confiscated a chunk of Microsoft's
market value overnight. It turns out the index had failed to
take into account the effects of a two-for-one stock split set
by Swedish telecom firm Ericsson.
Peg Pacey, who inaugurated The Striking Price column in
1977 and was Barron's options editor for 15 years, this
month was awarded the Harry Roth Memorial Press
Award for Lifetime Achievement. The award, given by the
Committee on Options Proposals was begun in memory of
options pioneer Harrison Roth, who died last fall.
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