Volatility Points to S&P 500 Gains With Widest Gap Since 1987

By Jeff Kearns

Jan. 13 (Bloomberg) -- Options traders are betting stock swings in the Standard & Poor’s 500 Index will decrease at the fastest rate since the aftermath of the market crash in 1987, a sign that equities may keep rallying.

The difference between the benchmark index’s historic volatility and a gauge of so-called implied volatility based on expected swings rose to the highest in 21 years, according to data compiled by Credit Suisse Group AG and Bloomberg. The gap widened as investors paid less to insure against price declines, sending the Chicago Board Options Exchange’s Three-Month Volatility Index lower.

Historical volatility must fall 25 percent to bring the measures into accord. The last time the difference was this wide, stocks climbed for two quarters, according to data compiled by Bloomberg. Declining volatility is usually bullish for equities because it shows growing investor confidence.

“We know a lot more than we knew four months ago,” said Michael McCarty, chief equity and options strategist at Meridian Equity Partners Inc., a New York-based brokerage. “Any time you have less uncertainty you have less risk, which is positive for equities.”

The S&P 500 gained 16 percent since reaching an 11-year low on Nov. 20 after President-elect Barrack Obama pledged to spend more than $1 trillion to revive the economy. The index still posted its worst year since the Great Depression in 2008 after lending froze and the U.S., Europe and Japan entered the first simultaneous recessions since World War II.

Lehman Collapse

Stock swings increased as the collapse of Lehman Brothers Holdings Inc. in September and government actions to bail out banks heightened concern losses would worsen. The S&P 500’s three-month historic volatility has more than quadrupled since June to 62.97. That’s 15.62 points higher than the CBOE’s Three- Month Volatility Index, a measure of expected swings in the S&P 500. They were as much as 29.7 points apart in the past month.

Stocks rallied the last time the difference was this large, just after the S&P 500 plunged 20 percent on Oct. 19, 1987. The index climbed 4.8 percent in the first quarter of 1988 and 12.4 percent that year. The VXO, a predecessor of today’s benchmark volatility index, decreased 31.7 percent in the first quarter and tumbled by 53 percent in 1988, its biggest annual drop.

“The volatility regime is going to shift significantly in the first quarter,” said Stu Rosenthal, who helps oversee $4 billion in volatility strategies at Volaris Volatility Management, a unit of Credit Suisse in New York. “The options market is predicting that the equity market will calm down.”

Cost of Protection

The CBOE’s three-month index uses a methodology similar to the VIX, which measures the cost of using options as insurance against stock declines and is calculated from prices for S&P 500 options no more than 30 days from expiration. Options give the right without the obligation to buy or sell a security at a set price and date. Implied volatility is a measure of expected price fluctuations and the key gauge of options prices.

Swings in the S&P 500 have been the biggest in the benchmark’s 80-year history. There were 18 gains or drops of more than 5 percent since Sept. 29. That’s more than half of the 35 changes of that size since 1955, according to S&P analyst Howard Silverblatt and data compiled by Bloomberg.

The VIX’s accuracy as a forecasting toll for stocks faltered last year. A calculation derived by traders from the VIX to predict the lowest level stocks were likely to reach was wrong from Sept. 29 to Oct. 30, the longest stretch ever.

The VIX’s predictive value may be restored as volatility recedes. Last year’s record price swings aren’t likely to be duplicated, options traders said.

“We saw some immense volatility in October and November,” said Randy Frederick, director of trading and derivative at Charles Schwab & Co. in Austin, Texas. “It’s going to be long time before we ever see that again.”

To contact the reporter on this story: Jeff Kearns in New York at jkearns3@bloomberg.net.