A sense of complacency that pervaded options markets during the first quarter is returning, as stocks have resumed their march toward record highs following April’s short-lived selloff.
Options traders are relatively relaxed about the risks facing markets, now that April’s selloff has come and gone.
This is feeding through to the prices of hedges that would protect an investor’s portfolio against a pullback, or even a market crash. These contracts have cheapened substantially since the beginning of May, according to Rocky Fishman, founder of Asym 500, a firm that provides data and analytics on the options market.
“[The] market’s brief period of concern about [interest] rates and geopolitics last month proved to be fleeting, and complacency has largely returned,” Fishman said in a report shared with MarketWatch on Friday.
One of the main reasons is that the rebound in stocks has caused the spread between the level of the Cboe Volatility Index (VIX) — better known as the Vix or Wall Street’s “fear gauge” — and how volatile stocks have actually been recently to shrink to one of its lowest readings in years, according to Fishman’s calculations.
The Vix — a popular measure of implied volatility, or how volatile traders expected markets to be — fell another 0.7% on Friday to finish at 12.57, its lowest end-of-day level since January.
The so-called fear gauge is based on activity in options linked to the S&P 500 that are expiring in roughly one month, and represents a barometer of how volatile investors expect the market will be in the interim.
A low Vix means crash insurance, in the form of Vix calls, is extremely cheap right now.
Fishman said that Vix call options with a strike price of 25 that expire in roughly 40 days are currently trading at 30 cents per contract, much less than what similar contracts cost one year ago.
A call represents a bet that an underlying index or stock will rise, while a put represents a bet that they will fall. The strike price is the level at which the holder of a call option can opt to purchase the underlying asset ahead of the contract’s expiration.
When it comes to options tied to the Vix, a call with such a far-out strike represents either a bet that the market could crash or insurance against such an outcome.
But even protection against a modest pullback has cheapened, as the so-called S&P 500 index skew has reversed nearly all of its April increase.
This means traders are once again shunning bearish puts while favoring bullish calls, Fishman said.
Cheap Vix calls, or index puts, could represent an opportunity for investors looking to bet, for instance, that next week’s consumer-price index report will come in hotter than expected.
Any evidence that the stalled slowdown in inflation could be more than just a temporary “bump” could weigh on stocks by forcing another rethink of when the Federal Reserve might begin cutting interest rates, market strategists said. And implied volatility typically rises faster when stocks are falling than when stocks are climbing.
At its lowest level in April, the S&P 500 was down 4.6% from its record close on March 28, according to FactSet data. As of Friday’s close, the large-cap index had reversed nearly all of that drop; it was up 8.6 points, or 0.2%, on the day to finish at 5,222.68 as it sealed a third consecutive weekly gain.
The Dow Jones Industrial Average has also clawed back most of its losses from last month. The blue-chip gauge rose for an eighth straight session on Friday, climbing 125.08 points, or 0.3%, to 39,512.84.
Meanwhile, the Nasdaq Composite shed 5.40 points, or less than 0.1%, to 16,340.87.
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