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FOR THE FIRST TIME SINCE Bear Stearns' 2008 collapse, the options market is signaling that investors aren't afraid of losing money in the stock market. If they fear anything, it is missing the opportunity to make money trading stocks.
This dramatic sentiment shift reflects a widespread belief on Wall Street that the Federal Reserve has greatly reduced, and perhaps even eliminated the risk of owning stocks during the next six to nine months, as the central bank implements the second coming of quantitative easing.
Anything could happen once QE2, as it's called, ends in June. But stocks are expected to rise as long as the Fed is buying $600 billion of Treasuries to further depress interest rates, effectively chasing investors out of bonds. "Skew," which reveals the bullish or bearish bias in the options market, has collapsed since the Fed's Nov. 3 announcement. Put volatility (which indicates fear of declines) fell dramatically, flattening skew—and that is a bullish indicator.
Put another way, QE2 is like a massive put option supporting equity prices.
Prior to Nov. 3, out-of-the-money puts on the Standard & Poor's 500 that expire in two months were about 9% more expensive than similarly situated calls. Now, two-month SPX skew is 5.8%. These percentages, though seemingly small, represent a big change in how investors view risk.
"You basically took the premium for puts versus calls and cut it in half," says Steven Williams, a derivatives strategist at Louis Capital, an institutional brokerage firm. "Someone with big capital came in and started selling puts."
The sudden emergence of "flat skew"—that is, put and call implied volatilities at equal levels—is dominating discussions in the options market. The new pricing dynamic indicates that investors now are overlooking the economic problems they have obsessed about since Bear Stearns collapsed and Lehman Brothers declared bankruptcy. The new focus is on making money as quickly as possible by trading stocks.
Williams, said he has never seen "risk premiums" disappear so quickly in the past 15 years. "Professional investors realize you can't fight City Hall," he says.
The absence of fear is evident in hundreds of stocks, and in all sectors. Michelle Skupp and Lillian Seidman Davis, derivatives strategists at Miller Tabak, have alerted clients to opportunities created by evenly priced bearish puts and bullish calls. Stocks they have flagged–and the list keeps growing—include Agrium (ticker: AGU), Petrohawk Energy (HK), Apple (AAPL), Adobe Systems (ADBE), BMC Software (BMC), Citrix Systems (CTXS), Google (GOOG), Netflix (NFLX), Priceline.com (PCLN) and Yahoo! (YHOO).
Other names on the list include Avon Products (AVP), Barnes & Noble (BKS), Mead Johnson Nutrition (MJN), Sears Holdings (SHLD) and Monsanto (MON), along with shares of gold and silver miners.
Seidman Davis and Skupp say the absence of fear means it is cheap to hedge stocks, even highfliers such as Apple, Netflix and Priceline.com. They recommend "collaring" stocks by selling upside calls, and buying downside puts to lock in gains.
"It is imprudent not to hedge part of your positions," Seidman Davis said. "All you need is another situation like Cisco Systems" (CSCO), whose dour profit outlook sent stocks lower last week.
Yet it is hard to convince investors to spend money hedging in anticipation of a stock decline when so many portfolio managers are lagging behind their industry benchmarks this year. Managers need to end the year with strong gains or their own pay packages may suffer.
Though investors appear high on that Street drug QE2, options-pricing anomalies always end in tears. Williams predicts "fear premiums" will return to index-options pricing just before QE2 ends.
Comments: steve.sears@barrons.com
http://twitter.com/smsearsBarrons
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