Don't Be Fooled by a Single-Digit VIX

Out-of-the-money put options on the SPX are unusually expensive right now

Senior Vice President of Research
Sep 25, 2017 at 8:44 AM
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If you're a long-time reader of Monday Morning Outlook, I apologize for what I'm about to say, as it is a refrain that you have heard before: We enter this week's trading with multiple benchmarks trading at psychological round-number levels that have historically marked hesitation points or profit-taking levels.

Specifically, perhaps the benchmark on most radars is the S&P 500 Index (SPX - 2,502.22), which took out the round 2,500 century mark to begin last week's trading, but eventually retreated back below it Friday morning, closing the week just 2 points above it.

Lingering just above is the 2,506-2,508 area, which represents the closing prices over the course of the two-day Federal Open Market Committee (FOMC) on Sept. 19-20. As expected, the Fed did not raise rates, and announced that in October it would begin the process of reducing the assets on its balance sheet. Since December 2016, the SPX closes around Fed policy decisions have marked hesitation and resistance levels in the days and weeks after the corresponding FOMC meetings, with even stiffer resistance coming into play after a rate hike. A notable exception is the rally that occurred immediately after the Feb. 1 meeting, when the Fed stayed pat on rates.

If the SPX behaves as it did in March through May, when the Fed was in focus with another century mark -- 2,400 -- in play, we may be in for a period of sideways action in the weeks ahead.

spx daily with fed meetings 0922

The Nasdaq Composite (COMP - 6,426.92) is trading around a level where it might be natural for profit-taking to come into play. The 6,459 level is a round 20% above last year's close and, as such, might be a level where those who are long technology stocks might decide to continue taking chips off the table, as they did in July -- also in the immediate aftermath of a Fed meeting.

The chart immediately below has horizontal lines that mark the round 10% and 20% levels above the 2016 close. Just as the COMP 5,921 level (10% above the 2016 close) acted as resistance from February through late April, it appears 6,459 (20% above last year's close) is similarly important.

comp daily since feb 0922

Another equity benchmark we're watching is the Russell 2000 Index (RUT - 1,450.78), which comes into the week at 1,450 -- site of its late-July peak, coincident with the FOMC meeting. Just as half century-mark levels have been of significance on the SPX, per past discussions, they have been of importance on the RUT, too.

For example, per the chart below, note in April 2016 how 1,150 acted as a brick wall, then was challenged a few more times after a successful test of support at the round 1,100 mark. The RUT finally sustained a breakout above 1,150 in July, and rallied straight to the next half-century mark at 1,250. It leveled off at 1,250 from August through October, before falling back to 1,150 pre-election, where it found support.

After a sizzling post-election rally, the 1,350 half-century mark acted as resistance before a modest short-term pullback, and has since been supportive on multiple occasions this year. Just as RUT 1,350 has been friendly to bulls, a fair question looking ahead is: Will RUT 1,450 be friendly to bears?

rut daily with half-century marks 0922

"Monday's action was a killer for those long call options on August VIX futures, as by settlement on Wednesday morning, 90% of August VIX calls expired out of the money, or worthless. However, immediately after VIX expiration, call volume exploded, as negative headlines surfaced and VIX call players looked to quickly replace calls that had just expired, either as portfolio hedges or speculative bets.

"Even though North Korea fears subsided, other uncertainties took center stage, and this may continue to contribute to elevated stock market volatility levels in the near term, relative to what we grew accustomed to in much of May through July."

    -- Monday Morning Outlook, August 21, 2017

"North Korean Foreign Minister Ri Yong Ho said late Thursday in New York that the country may consider a nuclear test of 'unprecedented scale' in the Pacific Ocean... Those comments came after North Korean leader Kim Jong Un said he was considering the 'highest level of hard-line countermeasure' in response to President Donald Trump's warning that the U.S. would annihilate North Korea if forced to defend itself or its allies."
    -- The Wall Street Journal, September 22, 2017

"Brexit and Donald Trump are the two biggest political risks, according to European companies surveyed by UBS. Describing 2017 as an 'exceptional accumulation of political event risk,' UBS asked corporates what they're most worried about and what they might do in response."
    -- Bloomberg, September 21, 2017

On the volatility front, the CBOE Volatility Index (VIX - 9.59) managed to move back into single digits last week, to my surprise. With the VIX going into last week's trading just above the round 10 level, followed by over 4 million September call options expiring in the middle of the week, along with the continuation of the war of words between North Korea and the U.S., my expectation would have been for the VIX to rally. Perhaps the thinking is, if North Korea reduces the entire U.S. to dust, there is no need to be in cash or put options -- so why react to this volley of words?

Nonetheless, do not be fooled by a single-digit VIX if you are looking to buy portfolio protection using out-of-the-money put index options. For example, the 14% implied volatility to insure against a 5% SPX decline in the next month (via the October 2,375-strike put) is twice the implied volatility of a 2,625-strike call, which is 5% above the current SPX level. It's also more than twice the SPX's current 20-day historical volatility of 5.69. In other words, out-of-the-money put options are expensive for those looking to hedge.

Around this time two years ago, the SPX's 5% out-of-the-money put implied vs. call implied ratio was only 1.65. Additionally, the 2017 ratio low of 1.60 occurred in February, right before the market headed south briefly. The 2016 lows of 1.50 occurred in February and late last year. Although readings between 1.50-1.65 are unusual, it is still worthwhile to know that the better deal is with the at-the-money options if you are looking to hedge.

But do not lose sight of the fact that, during this "exceptional accumulation of political event risk," as described by UBS, the market is hitting highs and call options are reasonably priced. Call options continue to be a great way to participate in upside, as the leverage provides you sizable money-making potential, while reducing your dollars at risk.

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