Investors Hedge Against Losses as Europe Fears Resurface

Date: Thursday, May 10, 2012
Author: Reuters

The resurgence of the euro zone's debt woes as a dominant force in the U.S. equity market has sparked a flurry of cautious bets in the options market as investors brace for more uncertainty.

The S&P 500 may have lost only a little over 1 percent for the week, but markets have become noticeably more volatile following elections in Greece and France that changed expectations for how the euro zone will deal with long-standing debt problems.

"People are scrambling for portfolio insurance and are picking up puts and selling stock as they prepare for a further breakdown in the U.S. stock market. At this point, investors are indifferent about the health of the U.S. economy with a clear focus on the fate of Greece," said Andrew Wilkinson, chief economic strategist at Miller Tabak & Co. Inc. in New York.

The CBOE Volatility index, Wall Street's so-called fear gauge, rose to its highest in over two months at 21.59 earlier on Wednesday [May 9]. The VIX, a 30-day risk forecast of stock market volatility conveyed by S&P 500 options, has come off its highs to 20.25, up 6.3 percent on Wednesday afternoon.

Bearish sentiment this week can be seen in the CBOE equity put-to-call ratio, which hit its most extreme level since August 2011, said Jason Goepfert, president of SentimenTrader.com in a report.

The ratio stood at 0.98 as of Tuesday's [May 8] close, according to CBOE's website, the latest data available.

Notably, Mr. Goepfert said this was not due to one or two stocks — the trading activity was evenly spread out across a broad array of securities and exchanges, increasing the confidence in this as a measure of pessimistic sentiment.

He also added that the surge in the put-to-call ratio to more than 50 percent beyond its six-month average is rare during a bull market, having occurred 31 times in the past 15 years. It resulted in a rebound over the next two days 74 percent of the time, averaging a gain of 1.2 percent.

"Given that and the S&P's ability to rebound off of that 1350 support area, long-side risk looks relatively low for the coming days," Mr. Goepfert said.

Other analysts support the idea that the equity market could rebound in short order. For the past couple of days, the S&P has fallen into a pattern of dropping by more than 1 percent in the early part of trading, only to bounce back after European markets close during the U.S. trading session.

"The current sell-off in the market has been quite orderly which is why the VIX is not higher," said optionMonster analyst Chris McKhann. "So traders are not wanting to buy protection at elevated levels as they do not think that the market will fall apart."

Greece is again the primary source of worry. Following the past weekend's elections, the parties that emerged with the most votes are given a slim chance of success of forming a government, which would mean new elections will be held in a matter of weeks.

Further compounding the uncertainty are developments in Spain, where officials are demanding banks there recognize more losses against bad loans.

"The tip of the iceberg is Greece and below that water level is Spain and Italy. It is as much a political issue as it is a financial one at this point," said Bill Luby, a private investor and author of a blog called "VIX and More," in San Francisco.

As the anxiety over developments in Europe runs high, "some investors are buying downside puts on the S&P 500 and the SPDR S&P 500 Trust to hedge their risk against additional losses," said WhatsTrading.com options strategist Frederic Ruffy.

Eight of the 10 most active options early on Wednesday in the U.S. options market were puts on the SPDR S&P 500 Trust, which is used as a proxy for the S&P 500 Index. The most active was the June $130 SPY strike put with the ETF trading down 0.5 percent at $135.80.

Put activity has been heavy this week with put buyers dominating the market on Tuesday, especially in sector exchange-traded funds, said derivative strategists at Susquehanna Financial Group in a note on Wednesday.

In the Materials Select Sector SPDR fund, the Industrial Select Sector SPDR fund, the SPDR S&P Metals and Mining Fund, SPDR Retail Trust and SPDR S&P Oil & Gas Exploration and Production Fund, SFG strategists have seen consistent May and June near-term put buyers dating back to late last week and Tuesday.

"While it is not uncommon to see investors buying downside puts, it may be viewed as noteworthy that it has been ongoing for several days," the SFG note said. SFG strategists view the trading as not outright bearish, but rather more protective for those long the market.