By Michael Tsang, Rita Nazareth and Adam Haigh
July 6 (Bloomberg) -- The biggest drop in U.S. options prices since 1998 masks growing anxiety over the stock market’s rebound, as traders pay more for bearish contracts than any time since before the failure of Lehman Brothers Holdings Inc.
Investors are spending the most since August 2008 to protect against a 10 percent decline in the Standard & Poor’s 500 Index versus wagers on an advance, according to data compiled by Bloomberg. That’s one month prior to New York-based Lehman’s bankruptcy. The premium on so-called put contracts increased even after the Chicago Board Options Exchange Volatility Index, a gauge of U.S. options prices known as the VIX, fell 40 percent last quarter.
Traders are locking in gains on the S&P 500, which rose as much as 40 percent since March, on concern the worst U.S. recession in a half century isn’t abating, according to Huntington Asset Management, BlackRock Inc. and Fiduciary Trust Co. The widening gap between bullish and bearish options belies the VIX’s retreat to below its level when Lehman collapsed and comes as U.S. companies prepare to report second-quarter earnings this week.
“Too many people are thinking the worst is over, life gets better from here,” said Peter Sorrentino, who helps manage $13.8 billion at Huntington Asset in Cincinnati. “We’re scratching our heads, going, ‘Something doesn’t feel right here.’ It’s probably better to have some insurance on the books.”
Pay-Off Price
Sorrentino, who expects the S&P 500 to retreat more than 10 percent from last week’s closing price of 896.42, said he bought options that pay off if the index declines to 775 in December. The “strike price,” or the level at which Sorrentino can exercise the contract, implies a 14 percent slump.
The S&P 500 fell 2.5 percent since June 26, the third straight weekly drop, after a worse-than-projected decrease in employment added to concern that rising joblessness will prolong the recession. Futures on the index lost 0.5 percent as of 10:44 a.m. in Tokyo today.
After losing almost $11 trillion during a 17-month bear market, U.S. equities have recouped 24 percent of their value since March 9 on speculation that corporate profits will rebound by year-end as economic growth resumes.
The S&P 500 climbed 15 percent in the second quarter, the biggest advance in a decade, as the government and Federal Reserve pledged $12.8 trillion to combat almost $1.5 trillion in losses at the world’s largest financial companies.
The rebound caused traders to pay less for options and pushed down the VIX, a measure of the S&P 500’s “implied volatility,” or expected price swings. It fell to a low of 25.35 on June 29 from 44.14 on March 31.
Not Normal
The reading indicates a 68 percent likelihood the S&P 500 will fluctuate as much as 7.3 percent in the next 30 days, according to data compiled by Bloomberg. That compares with the VIX’s all-time high of 80.86 in November, when traders priced in a swing of 23 percent in the S&P 500.
While prices for U.S. options have fallen, they are 38 percent above the average of 20.19 for the VIX over its 19-year history, a sign that financial markets have yet to return to “normal,” according to Carl Mason, head of U.S. equity derivatives strategy at BNP Paribas SA in New York.
The VIX ended last week at 27.95. On Sept. 15, the day Lehman declared the largest bankruptcy in U.S. history, the volatility index closed at 31.70.
“There’s still an element of caution,” Mason said. “Things have gotten to pre-Lehman levels, but I’m not sure if we can call that normal. The level of the VIX is quite elevated compared to historical levels.”
Cost of Protection
Traders are more inclined to buy insurance against stock market losses than they are to speculate on more gains, options trading shows. The implied volatility for contracts that lock in profits if the S&P 500 falls at least 10 percent in three months was 29.03 on June 29, according to data compiled by Bloomberg.
That compares with 20.20 for “call options” that pay off if the index rises at least 10 percent in the same period.
The difference between the prices of the two contracts, known as the implied volatility “skew,” steepened to 44 percent, the biggest premium since Aug. 28. The skew between contracts expiring in six months reached a nine-month high.
In Europe, demand for protection against losses has driven up skew on Dow Jones Euro Stoxx 50 Index options to the highest since November. Implied volatility for three-month bets on a 10 percent decline was 31.53 on July 1, compared with 23.08 for wagers on a 10 percent gain, according to data compiled by Bloomberg.
‘Back to Reality’
“The jury is still out on the recovery,” said Mark Lyttleton, a London-based manager at BlackRock, which oversaw $1.28 trillion globally as of March 31. “People are feeling the ‘green shoots’ now, but that will change over the next few months as they get back to reality.”
Call options on the S&P 500 convey the right, without the obligation, to purchase the index at a predetermined price on a specific date. S&P 500 put options give the buyer the right to sell at a set price on a future date.
Traders snapped up insurance against declines in the stock market as the World Bank said that the global recession this year will be deeper than it previously forecast, U.S consumer confidence unexpectedly weakened in June and delinquencies on the least-risky U.S. mortgages more than doubled.
Job cuts will probably push the U.S. unemployment rate to 10 percent by year-end and undermine consumer spending, which accounts for 70 percent of the economy, according to economists’ estimates compiled by Bloomberg.
Earnings at S&P 500 companies have fallen a record seven straight quarters and are forecast to decrease for two more before rebounding at the end of 2009, analysts’ estimates compiled by Bloomberg show. Analysts have trimmed projections for a fourth-quarter profit increase to 61 percent from a prediction of 95 percent when stocks began rallying in March.
Not Better Yet
“While we’ve avoided the doomsday scenario, the recovery is going to be modest,” said Michael Levine, a money manager at New York-based OppenheimerFunds Inc., which oversees about $150 billion. “There’s a concern that things have moved too far, too fast. Fundamentals just stopped getting worse, they haven’t gotten better yet. It’s not going to happen overnight.”
Bill O’Neill at Merrill Lynch Global Wealth Management says the biggest decline in the VIX since 1998 shows that the appetite for protection has decreased and the premium paid for S&P 500 puts versus calls will diminish as companies start reporting second-quarter earnings this week.
Investors are paying $12.06 for every dollar of operating profit analysts estimate S&P 500 companies will generate next year, a 41 percent discount to the average of $20.45 since 1998, data compiled by Bloomberg show.
Worth the Price?
“The potential for earnings upgrades is underappreciated,” said O’Neill, the London-based strategist at Merrill Lynch Global Wealth, which has $1.1 trillion in assets. “Valuations per se shouldn’t block an equity-market revival. The markets will be higher by the end of the year.”
Fiduciary Trust’s Michael Mullaney disagrees and says that the economy and corporate earnings haven’t improved enough to justify piling into equities after the S&P 500’s almost 40 percent rally from its March low.
“We need to have a dramatic improvement in the economy in order to keep on feeding the elevation in stock prices,” said Mullaney, a money manager at Fiduciary Trust in Boston, which oversees $7.5 billion. “All we can say about both the economy and earnings is that the forecast is just less bad.”
“People are taking some positions betting that if things don’t improve, they’ve got some protection,” he said.
To contact the reporters on this story: Michael Tsang in New York at mtsang1@bloomberg.net; Rita Nazareth in New York at rnazareth@bloomberg.net; Adam Haigh in London at ahaigh1@bloomberg.net.
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