What VIX Isn't Telling Us About Put Prices

How post-meltdown risk controls may be inflating put prices

by Adam Warner

Published on Apr 14, 2015 at 9:25 AM
Updated on Jun 24, 2020 at 10:16 AM

When the going gets "not tough," the tough get going … for puts. Something like that. This, from Callie Bost at Bloomberg:

"Prices for Standard & Poor's 500 Index put contracts, the options that act like insurance policies on stocks because they gain value when shares sink, have jumped this year to the highest levels on record relative to bullish calls. In one example, an option that appreciates if the market slides 10 percent by July has seen its cost shoot more than 120 percent above the corresponding bet on a rally. That's twice the average spread since 2005.

"… Divergences in price between bearish and bullish options can be seen all around the market. Puts expiring in July on the SPDR S&P 500 ETF Trust, the most popular U.S. exchange-traded fund, cost on average 105 percent more than calls this year, compared with 81 percent in 2014, Bloomberg data show.

"Three-month protection against a 10 percent drop in the Powershares QQQ Trust, the largest fund tracking technology stocks, were priced 93 percent above bullish options as of April 10, Bloomberg data show. That spread has averaged 51 percent since 2009."

On the margins, that sounds very bullish. The market is back near all-time highs. Realized volatility is drifting away. And the world at large sees all that and pays up for "insurance." That's contra-trend positioning 101, and fighting the wave tends to work poorly.

But alas, it's not so simple. It's never so simple.

Of course, it makes intuitive sense to want to lock in some gains into the rally. And I can't make the case that volatility looks high here with the CBOE Volatility Index (VIX) at four-month lows and not exactly thrombolic in the 12-13 range.

And, as the article points out, it's possible post-2008 risk controls are literally forcing some institutions into buying more protection. The implications of that are more "odd" than bullish, per se. It would manifest in elevated put prices like we're seeing. But it also suggests that the "real" price of volatility is lower than we see on the board, given that it implies somewhat artificial demand. That, in turns, implies that the puts are quite overpriced.

In all fairness, puts are always overpriced vs. actual risk, in the macro sense. Obviously, there are times when selling puts proves disastrous -- I'm talking about over the course of time. That's not breaking news … academic papers always find that. Forcing institutions to buy puts just adds to the overbid.

I'm not saying everyone should just roll put shorts over and over -- it's a high-wire act. I would say, though, that we all have the temptation to do the reverse … "lock in" stock gains with volatility buys that feel cheap. So, just know that what seems "cheap" is likely overpriced, and perhaps now it's very overpriced.

Disclaimer: Mr. Warner's opinions expressed above do not necessarily represent the views of Schaeffer's Investment Research.


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