from Steven Sears at Barrons:
The fear gauge has fallen, but it may be time to build up hedges.
ON THE CUSP OF FIRST-QUARTER-EARNINGS SEASON, the options market is percolating with talk about what to expect from Corporate America.
No one seems to expect that the majority of companies will report great results, though high are the hopes, which spring eternal on Wall Street as well as Main Street, that corporate executives will reveal on post-earnings conference calls that they see signs of an improving business conditions in the future.
For insights into how the Standard & Poor's 500 index could behave in the next 30 days, many investors reflexively turn to the Chicago Board Options Exchange's Market Volatility Index (VIX). The fear gauge, as the VIX is commonly called, is comprised of a strip of Standard & Poor's 500 puts and calls that is intended to give investors a sense of how options traders view the market during the next 30 days.
VIX closed Friday at 39.70, its lowest level since Jan. 28, while the Standard & Poor's 500 index closed at 842.50, the highest close for the market since Feb. 2.
Michael McCarty, chief equity and options strategist at Meridian Equity Partners, says, "While it is tempting to conclude that the drop below 40 for the VIX is cause for joy, it is important both to not over interpret the VIX and to recall what followed the last close below 40, specifically a significant sell-off in the market."
Many of Monday's pre-open trading notes cautioned investors to remain wary and wily despite the drop in the VIX and the gain in stock prices. Many strategists and traders advise investors to use the lull in options volatility as an opportunity to hedge stocks and portfolios against stock-market declines -- and to position for advances.
McCarty likes using VIX "call spreads" to hedge against an increase in volatility. VIX often rises when stock prices decrease. This could happen if earnings reports, and corporate outlooks, are particularly negative.
VIX was recently up about 6.5% at 42.31.
McCarty noted that April VIX futures, which reflect only May SPX options, closed at 41.70 on Friday, down only 1.25, while July VIX futures trade at a premium to "spot VIX," indicating that traders expect a volatility increase.
Krag "Buzz" Gregory, a Goldman Sachs' derivatives strategist who is widely respected for his volatility analysis, told clients Monday that Standard & Poor's 500 index implied volatility -- essentially, future expectations -- are priced below realized -- past results -- for virtually every strike price and expiration.
"Whether you are hedging or positioning for more upside, implied volatility looks cheap relative to potential realized in our view." Gregory told clients.
For example, Standard & Poor's 500 index call options that are 5% out-of-the-money are trading at 8.5 volatility points below one-month realized volatility. One lesson many traders have profitably learned is that it pays to own far-out-of-the-money options in volatile trending markets. On March 9, for example, May 900 calls were 33% out-of-the-money and could be bought for $1. Gregory said the calls are now worth $17.80.
At this crossroads in the stock market, there's something for bulls and bears in the options market, which is proof yet again of our favored old saw that options gives investors options.
