The stock market’s grind higher belies the jitters in the options market.
Domestic stocks have continued to notch gains as other global equities stumble. But U.S. stock volatility is diverging from actual equity performance, mimicking other risky assets around the world, analysts say. Stock volatility has been relatively high compared with major indexes’ strong gains.
The difference is jarring, given that the actual level of swings experienced by markets, known as realized volatility, is low. How low, exactly? The S&P 500 hasn’t moved up or down more than 1% for 56 days, the longest such streak since January, before U.S. markets slipped into correction territory.
But investor expectations of volatility remain high as investors gird for midterm elections and an historically turbulent season. A measure of options volatility dubbed skew has risen on small- and large-cap stocks alike, according to Credit Suisse—a sign of some fear in the market as investors reach for hedges that would protect against stock declines.
“Clearly, somebody’s worried,” says Mark Sebastian, founder of Option Pit. The volatility blowup from earlier this year has influenced investors and is leading them to drive up the cost of stock insurance in the market, he says.
Investors could be anticipating that global turbulence will eventually spill over into the U.S., especially because domestic stocks have been tranquil relative to the rest of the world and considered one of the safest of risky assets, some analysts say. For example, stocks in Hong Kong recently entered bear-market territory, and emerging markets have swung wildly in recent weeks.
Hedging on major U.S. stock indexes has driven up measures of expected volatility. Investors have been tapping put options and put spread trades on the tech-heavy Invesco QQQ Trustexchange-traded fund (ticker: QQQ), wrote Pravit Chintawongvanich, an equity derivatives strategist at Wells Fargo Securities, in a recent note.
Put options give investors the right to sell shares at a given price, known as a strike. Call options confer the right to buy.
For example, early this week the Cboe Volatility Index,or VIX, edged toward 15, though a measure of one-month realized volatility was at seven, Chintawongvanich says. This is greater than the normal divergence between the two metrics.
Investors are pricing in higher volatility especially for the week of the midterm elections, from Nov. 2 to Nov. 9, according to Wells Fargo, based on activity in S&P 500 options. “All of this suggests that S&P [volatility] could maintain a higher floor into the end of the year,” he says.
Investors positioning for volatility to stay higher or markets to ebb lower could tap an options put spread on the SPDR S&P 500ETF (SPY), says Sebastian. This would entail buying a put option on the ETF while simultaneously selling one with a lower strike price. The sale of one option helps to finance the purchase of the other.
Sebastian recommends buying a put with a $285 strike while selling one with a $275 strike, a trade that cost about $100 as of Thursday. The trade profits if the equity index falls and volatility remains high, but gains are capped if the fund goes below $275.
Conversely, investors looking to take a contrarian view that volatility will stay low or fall further could sell options puts, says Sebastian. This takes advantage of high options prices in the market right now and positions investors for expected volatility to meet realized volatility.
The trade entails selling a put option on the SPDR ETF tied to a $285 strike price, says Sebastian. This would earn the investor $200 for each contract sold as of Thursday, when the fund was trading at about $291.
But investors selling put options need to be aware they could be on the hook to buy shares at the designated strike price if they are exercised, or close out their positions at a loss should volatility perk up.
Gunjan Banerji covers options for The Wall Street Journal.