U.S. investors snap up cheap bets on stock downturn

U.S. investors snap up cheap bets on stock downturnThe stock market may be sitting near 18-month highs, and volatility has declined sharply, but that doesn’t mean investors aren’t worried about a downturn in the market.

Volatility has declined to a 22-month low, making it cheap for investors to bet on or hedge against a big drop in the market by buying S&P index put options as a hedge.

The Chicago Board Options Exchange Volatility Index, Wall Street’s favourite yardstick of investor sentiment, fell to a low of 16.21 on Tuesday, near levels not seen since May 2008, just prior to the steepest part of market sell-off.

The benchmark S&P 500 index closed Tuesday at an 18-month high, up more than 70 percent up from 12-year lows a year ago.

The rapid decline in volatility is due in part to low “realized” volatility, or historical volatility over the past 30 days, as the market has been relatively calm. Because of this, the premium to buy put options that are far out of the money is very cheap, and that has spurred investors, even in credit markets, to buy these puts.

“Over the last few days, there has been a noticeable uptick in S&P puts bought that were way out of the money,” said Scott Becker, derivatives strategist at Jefferies Equity Derivatives in New York.

As of Tuesday’s close, the number of existing positions held by investors in the June SPX put series stood at 190,998 contracts in the 800 strike, and 89,612 in the 850 strike, 110,845 in the 900 strike and 95,439 for the 950 strike price, according to Reuters data.

The S&P, at 1168.28, is nowhere near those levels – but if the average should start to drop after barely a correction since the run-up began more than a year ago, it will benefit those buying these puts now.

“Not only will the put options go up with the directional movement when the S&P 500 goes lower, but the volatility will increase, also causing options to go up. There are two factors working in its favour if the S&P pulls back,” said Randy Frederick, director of trading and derivatives at the Schwab Center for Financial Research in Austin, Texas.

The heavy open interest in S&P puts comes in part from credit investors, according to Scott Becker, derivatives strategist at Jefferies Equity Derivatives in New York.

Government debt yields are rising, and the sanguine nature of the equity market makes it a cheap place to hedge against market declines.

Credit metrics are beginning to reflect concern about mounting government debt. In the U.S. interest rate derivatives market, the cost to swap fixed-rate payments with floating-rate ones was below the rate the federal government pays on its 10-year debt, boosting concerns about sovereign credit.

U.S. investors snap up cheap bets on stock downturnSuch concern does not seem to be reflected in the volatility index. A declining VIX is commonly viewed as a harbinger of rising stock prices, while a rising VIX is seen as a warning of trouble ahead. With realized volatility low, the VIX is low, and those buying puts do not expect that to last.

“As much as things are cyclically stronger than people expect, this system is not perfectly fixed yet. You are going to see spikes (in VIX) continue to occur as these issues pop their head up,” said John Golub, chief strategist at UBS in New York.

“Should you be buying volatility when things are feeling more complacent, at least according to the VIX? Yes, a lot of really smart guys are doing that. That’s not crazy.” said John Golub, chief strategist at UBS in New York.

In mid-January, the VIX shot up from 17.5 to 27 when deficit concerns about Europe first broke out with Greece sovereign debt issues. The index rose 7.3 percent to 17.54 on Wednesday after Portugal’s credit rating was cut on deficit concerns.

The VIX is a 30-day risk forecast priced off Standard & Poor’s 500 index option prices and generally moves up when investors seek options to guard their portfolios against uncertainty as stocks fall sharply.