Sunday, January 2, 2011

Overcomplacency in the Market?

Following up on my outlook 2011, Brendan Conway of the WSJ reports, Options Flash a Caution Sign for '11:

The options market has a handful of signals for investors looking to the new year. The most glaring: Rougher trading in the stock market may be right around the corner.

Investors can plumb prices in the options market for hints on stocks' outlook, specific sectors or even scenarios like bank-stock dividend increases. The broadest measure of investor sentiment, the Chicago Board Options Exchange's Volatility Index, suggests the market is more confident than at any time since the financial crisis. The "fear index" of Standard & Poor's 500 options prices recently sunk to levels last seen in July 2007, suggesting a green light for stocks.

But sophisticated investors also trade futures on the VIX, as the gauge is also known, to hedge or act on their views a few months out. Those futures show skepticism in the form of much higher volatility expectations. March contracts point about 38% higher than recent VIX levels, a view that would bring some gyrations to the stock market if it bears out.

"You definitely have some upcoming catalysts that could drive volatility, such as earnings results or renewed European sovereign concerns," Credit Suisse equity derivatives strategist Terry Wilson said. Mr. Wilson, who predicts that a rockier market could come as soon as January, calls the relatively low prices of options an opportunity to guard stock portfolios.

The low VIX level itself, viewed against its elevated futures, strikes some observers as cautionary. Dan Bystrom, head of U.S. equity derivatives trading, at MF Global Inc., views the contrast as one of several signs of overcomplacency in the market, at a time when a variety of macroeconomic head winds could blow stocks back.

Diving down to specific sectors shows the market's quite placid volatility outlook isn't fully echoed in a few key areas. For instance, for stocks to advance on full throttle, emerging markets and financial services are two areas where many investors would want to see a bullish outlook.

But over-the-counter "outperformance" options on emerging markets and financials show the market isn't pricing in much direction for either. The odds look to be roughly even for emerging markets and financial stocks to outperform or to underperform the S&P 500 index next year, according to a recent analysis of those contracts by UBS AG's derivatives strategists.

UBS also looked at the options market's view for the S&P 500 to fall to the 1000 level any time this year. The probability came in at a not-insignificant 38%.

The uncertainty persists even though at least some of the stock market's most hotly anticipated positives are showing up in the options market. For instance, the prospect for bank-stock dividend increases was one of the factors boosting investor confidence this past fall. Options have a say on that subject, since their prices reflect an "implied dividend" in order for the contracts to trade. The outlook is growing more positive.

J.P. Morgan Chase & Co.'s options show a widely anticipated dividend increase, as do contracts for Wells Fargo & Co. and PNC Financial Services Group Inc., according to an MKM Partners analysis. US Bancorp is also pricing in an increase, albeit smaller, the firm found.

Much of the anxiety leads back to the same subjects that roiled markets in 2010: Europe's sovereign-debt woes, the potential overheating of the Chinese economy or the uneven state of the U.S. recovery.

"Volatility is going to be a lot like 2010—low for much of the year, but we may see some spikes as these macro head winds emerge from time to time," UBS AG equity derivatives strategist Mitchell Revsine said.

One area that bears an especially close look is the health of the U.S. consumer. Retail is a sector that strategists mention repeatedly when recommending which stocks to hedge.

Credit Suisse recently recommended locking up some of the holiday froth in retail stocks by buying put options on the SPDR S&P Retail exchange-traded fund. In particular, the firm read Best Buy Co.'s tough quarter as a sign that analysts have overshot the good news that many retailers can deliver.

"There's an opportunity to acquire cheap protection right now, because volatility in the market has been so muted lately," Credit Suisse's Mr. Wilson said.

Does the low VIX indicate overcomplacency in the market? Maybe, but I wouldn't read too much into the low VIX level. The VIX might remain low for an extended period as markets edge higher. Vol make look cheap now but a year from now, it can look cheaper. In fact, I read this interesting comment on the OnlyVix blog written a couple of weeks ago:

As I'm writing this VIX is trading at ~15.60, very close to it annual low of 15.23 back in April. This level is obviously significantly below what I expect a month ago, but also lower than investor expectations. The front month futures expiring on Wed, Dec 22 that have only 2 full trading days until expiration are still relatively juicy at 17.30! Of course the big question on everyone's mind is what is next for the market and for the VIX.

While the future is uncertain, I think that VIX has entered a low-volatility regime
(see my post here). I think economic uncertainty will not allow long-term VIX futures to fall much lower (back months are about 25) , which means that term structure premium is likely to remain high. If I'm correct in my hypothesis, we can see a steady decline in VXX due to increased rolling costs.
I also believe the VIX has entered a low-volatility regime. This means high frequency trading platforms will need to lever up to make the extra juice. Pensions should be taking a closer look at volatility arbitrage, either internally or through external managers that specialize in this strategy. Pensions should also be using some basic option strategies to protect their downside and/or enhance their returns. Some practitioners even feel that investors should treat volatility as a separate asset class. I agree, if done properly, investors can make money trading vol.

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