`Fantastic' Option Market Wins Profit on Goldman as Stocks Fall

By Jeff Kearns and Gareth Gore

Oct. 6 (Bloomberg) -- The same credit-market rout that sent stocks to the steepest loss in two decades is also making it the best year ever for options traders.

U.S. equity derivative prices and trading surged to records as one of the worst months for the Standard & Poor's 500 Index since the Great Depression wiped out three years of stock market gains. The retreat drove the Chicago Board Options Exchange Volatility Index, a measure of how much options cost, to the highest level in its 18-year history.

Huntington Asset Management returned 70 percent in two weeks by selling contracts on Goldman Sachs Group Inc., the Wall Street bank that sold $5 billion of preferred stock to Warren Buffett. Target Corp.'s 25 percent plunge yielded about $12 for every contract traded by Scoggin Capital Management LP using a so- called no-cost collar. Contracts for Coca-Cola Co., Wal-Mart Stores Inc. and Campbell Soup Co. surged as much as 119 percent since the end of 2007, according to the implied volatility of options expiring in 30 days.

``It's astronomical,'' said Peter Sorrentino, who helps manage $16.5 billion at Huntington in Cincinnati, including $150 million in options. ``You're selling insurance to people who are scrambling and the markets are moving faster than they can react. It's heavily skewed toward fear.''

Even as the VIX, as the CBOE index is known, fell 0.3 percent to 45.14 on Oct. 3 after Congress approved a $700 billion financial-market rescue plan, volatility may remain high as concern grows the legislation isn't enough to unlock credit markets and restore confidence in the nation's banking system, said Michael Schwartz, options chief at Oppenheimer & Co. in New York. The S&P 500 fell 1.4 percent after the vote, capping its worst weekly decline since September 2001.

`Not Over Yet'

``Now that the vote has been made, volatility, which is a reflection of fear, is still going to be high,'' said Schwartz, the ``dean of options strategists,'' according to SmartMoney magazine. ``The implication of this credit squeeze is that it's not over yet.''

The VIX surged to a record 46.72 on Sept. 29 after the House of Representatives initially rejected the rescue plan. That pushed the S&P 500 to an 8.8 percent decline, the most since the 1987 crash, as borrowing costs climbed. The stock index lost 9.1 percent in September, the 12th-worst month since World War II.

The all-time high in the VIX meant investors paid 2 1/2 times more for S&P 500 options than they did in 2007, based on its average level last year. The measure, calculated from the prices paid for S&P 500 options, has exceeded 30 for 15 consecutive days, the longest streak since 2002.

`Worst Fear'

``This is the worst fear that I can think of in my career,'' said John Wilson, 63, co-director of equity strategy at Morgan Keegan & Co., which manages $120 billion in Memphis, Tennessee.

September's market gyrations sent trading of options on U.S. stocks, indexes and exchange-traded funds to an all-time high of 375 million contracts, according to the Chicago-based Options Clearing Corp. Volume was almost double the figure from a year earlier.

``People are nervous and they want protection for their portfolio, so they'll pay a premium,'' said Adam Stern, who oversees more than $1 billion at AM Investment Partners, a New York-based hedge fund that invests in options. ``It's possible to make a bit of money as people bid for that premium.''

Options are derivatives, or securities that derive their value from an underlying asset. Calls give the right to buy a security for a certain amount, the strike price, by a given date. Puts convey the right to sell.

Investors who sold one-month call options on the S&P 500 with strike prices equal to the current level of the index collected a 3.6 percent premium, more than double the 1.7 percent average over the last 22 years, according to CBOE data.

Buy-Write Strategy

The CBOE S&P 500 BuyWrite Index lost 5.8 percent last month, less than the stock benchmark's decline. The gauge tracks the performance of investing in the S&P 500 and then selling calls with strike prices higher than the index's current level. The strategy works best if the calls remain ``out of the money,'' meaning the S&P 500 stays below the strike price, preventing the contract's buyer from exercising it.

Diane Garnick, who helps oversee $500 billion as a New York- based investment strategist at Invesco Ltd., recommends that retirement funds and endowments use a buy-write strategy.

``If ever there was an environment where options overwriting makes sense, it's now,'' she said. ``When you sell those calls, you get extra income.''

Huntington's Chip Hendon sold October $80 puts linked to New York-based Goldman Sachs on Sept. 16 as the stock tumbled to an almost three-year low of $133.01. He collected a premium of $3.72 for each contract. Because that put can now be purchased for $1.13, Huntington has gotten a 70 percent return.

September $42.50 Call

Investors who initiated a buy-write strategy on New York- based American Express Co. on Aug. 15 would have generated a 5.5 percent profit by the next month's expiration on Sept. 19. That scenario, based on selling the September $42.50 call, outperformed owning the shares, which rose 3.4 percent to $40.40 during the period, while the S&P 500 declined 3.3 percent.

Craig Effron, who oversees $3.1 billion as co-founder of Scoggin Capital, bet that Target would retreat after the second- largest U.S. discount retailer surged 33 percent in less than two months to $57.89 on Sept. 8.

`Parabolic Move'

``We thought that seemed like a parabolic move, which we're always suspect of,'' Effron said. ``But I didn't want to short the stock in case I was wrong.''

Effron used a modified version of a ``collar'' strategy, buying the October $55 puts while selling the October $60 calls on Sept. 16 as the stock remained near the same price. Effron pulled in about $12 for each of his positions, which he declined to quantify.

Implied volatility, a key gauge of option prices, reached the highest levels since the end of 2007 last week for Atlanta- based Coca-Cola, Bentonville, Arkansas-based Wal-Mart Stores, and Camden, New Jersey-based Campbell Soup. Coca-Cola increased as much as 119 percent to 40.69, Wal-Mart added 58 percent to 40.61 and Campbell Soup rose 76 percent to 38.94.

``It's a fantastic time to trade options,'' said Jody Smith, a London-based volatility trading analyst at Russell Investments, which oversees about $213 billion. ``You have people that need to own contracts, people who want to sell, and there's a lot of opportunity to put on positions and take them off.''

To contact the reporters on this story: Jeff Kearns in New York at jkearns3@bloomberg.net; Gareth Gore in Madrid ggore1@bloomberg.net.