Options Show S&P 500 Rally in Peril Amid Bearish Bets on VIX

By Jeff Kearns

Dec. 11 (Bloomberg) -- Traders are boosting bets in the U.S. options market that this year’s rally in the Standard & Poor’s 500 Index won’t last.

The fourth most-active options to sell the SPDR Trust Series 1 yesterday were December 2010 $55 puts, contracts with so-called strike prices more than 50 percent below the cost of the exchange-traded fund known as the SPY. S&P 500 options to protect against losses in 2010 are 28 percent more expensive than one-month contracts, among the highest premiums in the past five years, according to data compiled by Bloomberg.

“The real news next year would be if we don’t get a 5-to 10-percent correction,” said Stephen Wood, who helps manage $170 billion as chief market strategist for North America at Russell Investments in New York. “The rally since March has been all but uninterrupted.”

Speculation is increasing that the advance that restored $5 trillion to U.S. equities will falter as the Federal Reserve raises interest rates and earnings fail to match analysts’ projections. Bearish bets in the options market last peaked a month before New York-based Lehman Brothers Holdings Inc. filed for the biggest-ever bankruptcy in September 2008, sending the S&P 500 down 46 percent in the next six months.

The SPY, which has rallied 62 percent since March, added 0.6 percent to $110.64 in New York yesterday. The December 2010 $55 puts changed hands 48,577 times, the second-highest volume since they began trading almost a year ago, and 76 percent of them traded at the ask price, indicating buyers initiated the majority of the transactions.

Betting on Swings

Contracts with a strike price so far below the ETF price often aren’t bets a security will fall that much. Rather, they’re purchased by traders speculating that stock swings will increase, boosting demand for insurance against losses and increasing the contract’s price, said Dean Curnutt, president of New York-based Macro Risk Advisers LLC.

“If market declines materialize, you’ll see a substantial pickup in volatility, and these puts have very strong volatility characteristics for the buyer,” said Curnutt, whose firm advises professional investors on derivatives strategies. “As volatility goes up, these far-out-of-the-money puts have a very strong and favorable reaction to increases.”

Puts give investors the right to sell an asset for a given price through a specified date. When the cost of the security is higher than the option’s so-called strike price, the put is said to be out of the money. Traders favor puts farther from being in the money because they are usually cheaper and therefore offer bigger potential profits.

Opposite Directions

The Chicago Board Options Exchange Volatility Index is heading for the steepest yearly retreat in its two-decade history. Futures on the so-called VIX are pricing in a 27 percent gain for the options-market benchmark by March. The S&P 500 and VIX move in opposite directions more than 80 percent of the time, according to data compiled by Bloomberg.

Stock market bulls are counting on U.S. gross domestic product growth of 2.6 percent in 2010 and a 25 percent increase in per-share earnings at S&P 500 companies, according to the average economist and analyst estimates in Bloomberg surveys.

The VIX, a measure of how much traders are paying for insurance against S&P 500 in the next month losses, may almost double next year on concern the stock market rally since March outpaced prospects for economic and earnings growth, according to David Rosenberg, chief economist at Gluskin Sheff & Associates Inc. in Toronto. After surging to a record 80.86 in November 2008, the VIX has fallen to 22.32.

‘Heightened Volatility’

“We’ll be in a year of heightened volatility,” Rosenberg said in an interview this week. “I see more of a 30 to 40 range in the VIX.”

Futures on the VIX, which hasn’t closed above 30 since October, also show investors betting that the gauge will rebound. January contracts closed at 26.10 yesterday, while those expiring in March ended at 28.25.

One-year implied volatility, a gauge of options prices, on the S&P 500 is 24.70, or 5.5 points higher than 30-day contracts, and the gap widened to 6.83 points on Nov. 24, the highest in at least five years, Bloomberg data show. The last time the gap approached the current level was in August 2008, just before Lehman’s bankruptcy.

The December 2010 $55 puts on the SPY decreased 1.6 percent to 60 cents yesterday. Their trading volume equaled two-fifths of their 119,073 open interest, or outstanding contracts.

“Someone’s buying these as protection,” said Chris Rich, head options strategist at JonesTrading Institutional Services LLC in Chicago. “It’s definitely someone hedging a long position, and what’s worthy of note is that it’s right at half of where it’s trading now.”

To contact the reporter on this story: Jeff Kearns in New York at jkearns3@bloomberg.net.

Last Updated: December 11, 2009 00:01 EST