Analysts: Low volatility is a time to buy options

* Options risk gauge is below long-term average of 20.40

* Volatility data suggests likely sell-off in Dec-Jan

By Doris Frankel

CHICAGO, Oct 25 (BestGrowthStock) – Inexpensive options prices are
providing a sweet spot for investors to hedge their recent
gains or place directional bets as U.S. stocks (Read more about the stock market today. ) grind higher and
concerns over an equity sell-off loom.

Several analysts advocate limited risk strategies using
options that allow investors to protect their bullish exposure
while participating in additional upside in stocks.

With potential resistance for the S&P 500 index (.SPX: ) at
the 1,200 area, purchasing portfolio protection is prudent,
said Todd Salamone, senior vice president of research at
Schaeffer’s Investment Research.

“Now is the opportune time to acquire cheap insurance with
short-term out-of-the-money index or exchange-traded fund put
options, given the possible market-moving catalysts on the
immediate horizon,” he said.

The S&P on Monday afternoon was trading at about 1,187
points.

Salamone recommends investors keep their long exposure
because continued hedge fund buying and the potential of money
moving from the sidelines could keep the bull market intact.

“Indications are that market strength is coming from hedge
funds, who will buy index or ETF puts to hedge any equities
that they are accumulating,” he said.

Concurrent with the run-up in U.S. equities, the 30-day
risk forecast of stock market volatility known as the VIX, the
CBOE Volatility Index (.VIX: ), has eased significantly.

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Graphic: CBOE volatility Index http://r.reuters.com/fag22q

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The VIX has recently been below its long-term average of
20.40 and is approaching the low end of its range since July
2007. Low volatility, a key component of an options price,
means that options premiums are relatively inexpensive.

Jim Strugger, derivatives strategist at MKM Partners, a
Stamford, Connecticut-based research firm, believes prudent
risk management dictates that gains should be taken, or at
least hedged into this market strength.

Strugger said options are currently inexpensive in the
energy, telecom services, financial, utility and materials
sectors in the S&P 500 universe.

He recommends investors sitting on gains in these sectors
look at either buying puts outright to hedge long stock
positions or replace the stock with calls to maintain exposure
while greatly reducing capital at risk.

In a report last week, Goldman Sachs advised investors to
take advantage of inexpensive financial options to gain upside
exposure with limited risk as volatility could be high in the
coming weeks. [nN21208551.

Since July, institutional broker-dealer WJB Capital Group
has suggested investors replace their long stock positions that
have gained more than 9 percent with buying calls, known as a
stock replacement strategy.

The trade uses profits from selling a long stock position
that has appreciated significantly to buy a bullish call
option. If the stock continues to rally, the call premium
increases and if the stock falls, the only risk is the premium
paid for the calls.

The strategy has proved to work well on stocks with low
risk premium levels, said WJB’s director of derivative
investment strategies, Scott Fullman, who advocates its
continued use.

Many analysts expect that corporate earnings will help
drive the stock market higher. Of the 31 percent of S&P 500
companies that have quarterly reported results, 83 percent have
beaten estimates, according to Thomson Reuters data.

In addition, the prospect of more asset-buying by the
Federal Reserve in a new quantitative easing program has helped
lift the S&P 500 as much as 15 percent since late August.

Federal Reserve Bank policy makers meet next week and are
widely expected to pump more cash into the financial system to
try to stimulate the fragile recovery. Investors will also be
focusing on the Nov. 2 midterm congressional elections.

But the market could be poised for a sell-off if the VIX
descends to its long term 15-18 range set since July 2007.

“Once we get down there, then there are significant
cautionary flags and the potential exists for the VIX to spike
off of those levels,” Strugger said.

Meanwhile, volatility data suggests options traders are far
more concerned about an equity sell-off later this year rather
than November.

The futures based on the VIX are pricing a smaller increase
in volatility through November and a higher probability through
the December and January period, said Chris McKhann, an analyst
at optionMonster.com in Chicago.
(Reporting by Doris Frankel; Editing by Leslie Adler)

Analysts: Low volatility is a time to buy options