Low volatility is a time to buy options: analysts

By Doris Frankel

CHICAGO (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.

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.

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 November 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)

Low volatility is a time to buy options: analysts