- 02Nov
(Reuters) - In a week of great uncertainty, with the announcement of a massive Federal Reserve buying program widely expected and the jobs report for October due, options traders have become more defensive as they await the unknown.
The most familiar measure of investor anxiety, the CBOE Volatility Index .VIX, has risen for six straight days, but actual volatility in the S&P 500 index .SPX is at its lowest since April.
The results of the U.S. midterm elections on Tuesday, the size and scope of the anticipated Fed Treasury-buying program and the U.S. employment report at the end of the week all could dictate the market's tone for the rest of the year and into 2011.
"It's crunch time for the markets. The two most critical events are the Federal Reserve policy statement and the jobs report," said Andrew Wilkinson, senior market analyst at Interactive Brokers Group.
"Both are essentially a coin toss, which is why option players are not selling volatility," he said.
Expectations for market-friendly outcomes has helped the rally grow deep roots. The S&P 500 is up 12.9 percent since the end of August.
The election and quantitative easing by the Fed hold the possibility for a sharp market sell-off, for the market seems to have discounted all good news, wrote Larry McMillan, president of options research firm McMillan Analysis Corp, on Tuesday.
"The jobs report is more of a 50-50 thing and could move the market either way," he said.
IMPLIED VOLATILITY UP
Optimism over the election outcome and the Fed meeting has driven the stock market in the last two months. But additional nervousness has accompanied the rally.
Implied volatility normally falls as stocks rise, but this is no typical period.
The VIX closed at 21.83 on Monday, the highest in a month. The index is up 16.2 percent while the S&P rose only 0.1 percent over the past six days, a sign of worry that a sell-off could ensue in coming weeks.
"We believe the failed break-out attempt by the S&P 500 to reach above the 1,200 level on Monday helped escalate concerns for a potential correction during or following this week's events," said Scott Fullman, director of derivative investment strategy at WJB Capital Group.
But as the VIX nudged higher, realized volatility, which measures past daily ups-and-downs in the S&P 500, has fallen dramatically.
Realized volatility over the past 20 days for the SPX stood at 10.97 percent on Monday, the lowest since April 26, said Michael McCarty, managing partner at institutional derivatives firm in Austin, Texas.
The divergence bodes ill for stocks in the near term.
"Equity managers, mutual funds and hedge funds have been buying protective puts while remaining long equities. Last week the desire for protection shifted and became immediate versus year-end exposure," McCarty said.
However, Goldman Sachs equity derivatives strategists in a report note that realized volatility often remains low around the election. In the six elections since 1950 that resulted in a change of congressional control, realized volatility averaged 11 for the three months after the election.
HEALTHY PAUSE?
"We view this equity market and psychological pause as suggested by the VIX as healthy and expect the aggregate effect of this week's events to trigger an advance toward the 2010 highs of around 1,216 for the S&P 500," said MKM Partners derivatives strategist Jim Strugger.
Technically, a close above 1,195 for the S&P 500 could bring the benchmark to the April high of 1,220, said Stifel Nicolaus options market strategist Elliot Spar.
A clear break of the 10-day moving average of 1,181 on Monday, however, could be a catalyst for the start of a pullback to the 1,155 area last seen on October 12 and possibly the 200-day moving average of 1,123.
Goldman strategists recommend hedging for those who are fully invested and have participated in the recent market rally. "In a scenario where the market pulls back minus 2.5 percent by market close Wednesday, the optimal hedge is buying SPX November 1,125 puts for $6.60," Goldman said.
