Volatility swoon opens up options market opportunities

NEW YORK (Reuters) - Whether you believe the rally in U.S. stocks has run out of steam or expect shares to soar on to new highs, the recent slump in stock market volatility has opened up big opportunities for traders in the options market.

A trader works on the floor of the New York Stock Exchange (NYSE) in Manhattan, New York City, U.S., January 20, 2017. REUTERS/Stephen Yang

U.S. stocks have risen about 6.5 percent since the November 8 election of President Donald Trump, but have stalled in the past few weeks on concerns Wall Street’s priorities are not in synch with the administration’s.

But stock market volatility has plummeted in an apparent disconnect from current political and policy risks.

On Wednesday, the CBOE Volatility Index .VIX, the widely followed barometer of near-term stock market gyrations, briefly dipped to 9.97, the lowest in a decade.

While investors may be tempted to book profits by selling out of stocks at all-time highs, such a move would run the risk of missing out on future gains.

The collapse in volatility has made for cheaper options prices and serves up an attractive opportunity. With options underpricing risk, they provide a more attractive way to trade these uncertain markets than sitting in cash, BofA Merrill Lynch Global Research analysts said in a note on Tuesday.

“Using options, investors can profit regardless of which way markets break, and there is a strong chance they move more this year than what options imply,” the BofA Merrill Lynch note said.

Market experts recommend a stock replacement strategy that may appeal to traders looking to add a dash of options to their portfolio.

The strategy involves selling a part of a portfolio of shares and using some of the proceeds to buy call options. The purchase of a call contract conveys the right to buy shares at a fixed price in the future.

“This allows you to continue to participate if the market runs higher, but it reduces your expense risk if you are wrong and the market sort of sidelines or collapses,” said Richard Selvala, chief executive at Harvest Volatility Management LLC.

The current volatility environment, combined with stocks hitting all-time highs, relatively high valuations and a greater level of uncertainty from the new U.S. administration, means stock replacements have never looked more compelling, Selvala said.

Options experts also recommend overwriting - a strategy where an investor who owns shares sells calls against the equity position.

While selling calls when options prices are depressed may seem counterintuitive, strategists point to the wide spread between implied and historical moves - the gap between how much stocks are expected to move and how much they have actually moved in the past.

For instance, the spread between S&P 500 index .SPX 3-month implied volatility and S&P 500 1-month historical volatility is currently higher than it has been for 80 percent of the time over the last two years, per Thomson Reuters data.

The overwriting strategy allows the harvesting of this volatility risk premium embedded in options prices, Anand Omprakash, equity and derivative strategist at BNP Paribas, said.

“It’s a nice way to take advantage of the situation while still being positioned for a bullish market,” he said.

Reporting by Saqib Iqbal Ahmed; Editing by Rodrigo Campos