Thursday, August 15, 2013

Investor Options

               The current status of the stock market has some investors worried about the 54 month bull market nearing its end.  Are there reasons for this fear?  Looking at bond yields, inconsistency in the housing development market, and the looming decrease in quantitative easing will shed some light.  10 year Treasury bond yields have traditionally opposed the market.  During their rise, the market was generally stagnant.  Upon their decline beginning in the mid 1980’s, the market began to rise.  In 1987, there was a disconnect between the bond yield rising and the market.  The market continued to rise until a staggering decline in the market restored the balance.  What we see now is a similar trend regarding the bonds relative to the market; i.e. both have been increasing over the past few months.  The homebuilding index ETF, XHB, peaked in May as the S&P 500 peaked.  However, while the S&P 500 continued to climb, the homebuilding index has fallen off.  Like the bond yields, this is out of step with the general trend. 
                A tremendous amount of influence on the market is held by the Federal Reserve.  An announcement that hinted towards a decrease in quantitative easing (QE) on June 19 caused the S&P 500 to decrease by 2.5%.  This drop happened without an actual change in the policy, simply a suggestion that it may begin to taper.  Enter the Chicago Board Options Exchange’s Volatility Index (VIX).  This tracks volatility in the S&P 500.  As shown in the figure below, spikes occurred during the 2008 financial crisis, and again in June of 2010 and June of 2011, corresponding to the termination of QE1 and QE2.  A 23% increase occurred in the VIX when the aforementioned 2.5% drop in the S&P 50 occurred.  Some investors who believe that the market will take a downturn are using the VIX to hedge their investments.  They are doing this though purchasing call orders on VIX.  This is to ensure that if the market falls and VIX spikes, they can profit from the right to purchase the volatility index at a low price.  Call orders were at an all-time high of 1.12 million on Tuesday.  One strategy being employed is to purchase calls at a lower price and sell calls at a higher price to offset the cost of the purchased calls.  This limits the profitability of the call option placed on the lower price.  Of course, this is not an issue if the price of VIX never exceeds the strike price of the calls sold.  One particular fund manager has purchased calls at 10, 11, and 12 dollars, while selling calls at 19, 20, and 21 dollars.  Today’s (August 15) performance already has this strategy in the money as VIX closed at $14.56, a 12% daily gain.

Figure 1: VIX 5 year chart

                Taking the bond yields, homebuilding index, and uncertainty surrounding the Federal Reserve into account relative to how they affect the market, it does appear that there is reason for investors to believe the bull market will turn bearish.  Options can serve investors looking to hedge against such a downturn.  Several options can result in profits assuming this bearish assumption is correct.  One can purchase put options on a market index, sell call options on the market index, sell put options on the volatility index, or do what was described above and buy call options on the volatility index.  One could short sell market indexes as well.  With options, one thing is certain: investors are not without choices.

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