What Wall of Worry? Implied Volatilities are Low

If this rally is climbing a wall of worry shouldn’t there be more of a risk premium?

Many market pundits are calling the recent advance in share prices “The rally that everyone hates!” It seems apparent that many money managers are sitting on the sidelines, unwilling or too worried to buy into a market that seems to be facing headwinds of uncertainty. The European debt crisis is certainly not resolved, earnings haven’t been off the charts positive, economic and unemployment numbers are still depressed and I have heard there is a presidential election coming up.

So why is the VIX currently* bouncing around 14%? Granted the 6 week rally is moving at a snail’s pace. The SPDR S&P 500 ETF (SPY) 50 day historical volatility, showing the actual movement in the price of the stock is measured today at 8.25%! However, with the market back at yearly highs, levels not seen since March, the low implied volatility, or the premiums charged for options and the skew charged for downside hedges may be really compelling. Granted the futures on the VIX index point to a premium for future volatility, but given that the spot VIX is so low, those forwards are higher, but certainly not high by historical measures. Also, looking at the implied volatilities for the ATM options in the SPY and specifically the downside puts in the SPY may indicate an opportunity for transacting a low cost option hedge.

Those investors who are long the market already and are concerned about a potential selloff leading into the election might want to look at buying a portfolio put as a hedge. The mechanics of the portfolio put is to purchase a put option on a broad based ETF to hedge your entire portfolio of stock exposure.

Looking at October options, they have 59 days to go to expiration, and though expiration Friday on October 19th will not cover thru the November election, the result of the election may become apparent to all in October. Any surprise either way may be the catalyst for market movement. The implied vol of the October 140 calls is about 15% and command a premium of $2.70 or 1.9% of the current spot of the SPY ($142.25). So for 1.9% investors can be long the market with a little less worry of a market selloff. To determine how much exposure you currently have to the market use the Risk Viewer Tool on your OptionsHouse platform, where you can see the Dollar Delta exposure on the Greeks tab.

I suggest using the Beta Weighted feature to get an accurate measure of your exposure to the overall market.  On this virtual portfolio I have long stock positions adding up to 104,000 Dollar Deltas. To hedge a this position in the market, one would buy 7 put options.  $104,000 / current SPY price (142.25 * 100) = 14,225 = 7.3 options.  After buying the puts, you will still be long the market, but your downside exposure will be hedged.

What if you aren’t already in the market?

If you have not participated in the rally and fear missing out on more upside, using options here instead of long stock may be very attractive from a risk /reward perspective.  With premiums so low traders can use an In the Money callas a hedge way to get long exposure to the market .  Again, use the calculation to determine the correct amount of exposure thru options.  Options are levered instruments which can sometimes cause new traders to buy too much exposure relative to your investment portfolio.   Using the SPY again as a proxy for the overall market, you could look at the September 140 call to have upside exposure for the next 31 days.  This option is $2.25 in the money, and can be purchased at $3.50.  This premium paid is the maximum risk of this position while the upside breakeven is 145.75 in the ETF. Say you want to invest $50,000 in the overall market, again divide $50,000 by the SPY price to determine whether to buy 3 or 4 options.  Instead of paying $50,000 to buy the stock, you can have a hedge position giving upside exposure spending 4 X 3.50 X 100 = $1400!

Steve Claussen

Chief Investment Strategist




*Prices and levels taken midday 8/21/12