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A wall of worry is building in the options market as the stock market surges higher at the onset of a new trading year.
Sophisticated investors are actively buying call options on the Chicago Board Options Exchange's Volatility Index (VIX) that would likely increase in value if the Standard & Poor's 500 index falls sharply by the middle of February.
These VIX call options will pay off if the VIX spikes to 27.50 in February from its current level of about 18. Such dire expectations are sharply at odds with bullish reports from major banks and news organizations detailing why the stock market will rise sharply in 2011.
The bearish posturing in VIX is ample evidence that some investors have not forgotten that the stock market never advances in a straight line, and never misses an opportunity to hurt the most people, most of the time.
"We're moving toward a euphoric peak where the market in aggregate will start acting like a bunch of rare-earth stocks," says Jim Strugger, MKM Partners' derivatives strategist.
Rare-earth stocks, like Molycorp (ticker: MCP), are viewed as little more than momentum trades propelled by a compelling thesis that prices will increase because China controls most of the world's rare-earth minerals and will increasingly limit exports. (Rare-earth minerals are increasingly in demand for their use in a wide range of electronic products including smartphones.)
Everyone intuitively understands the rare-earth logic just as everyone gets the idea that it makes sense to buy U.S. stocks because the Federal Reserve's latest phase of quantitative easing has demolished the prospect of returns in the bond market.
It is easy to sound Pollyannish about the stock market's recent strength, but the concerns evidenced in the options market are more than just naysaying.
January is traditionally a strong month for the stock market as investors, big and small, reposition portfolios for a new year. Inevitably, though, the stock market loses its upward momentum, and declines.
The retreat could be caused by a number of potential market hobgoblins including tension between North Korea and South Korea, European sovereign debt crisis or even serious financial troubles that could roil the municipal debt markets in the U.S.
The expected decline will likely not be the typical garden-variety correction. The drop will be sharp and quick, and more of a tradable event than a major maelstrom.
If expectations were for a more profound decline, the options market would be filling with large swaths of bearish trading, and it is not.
Strugger thinks that the VIX will tumble to 15 by the end of January but will then spike to 30 in February.
His view is reflected by VIX's trading patterns. Investors are buying VIX January 27.50 calls and February 27.50 calls. They are active in other VIX calls, including the February 30 and 35 strike price, but the action is less an indication of a future volatility spike, and driven more by a desire to lower the cost of buying 27.50 calls that cost just under $1.00.
Comments: steve.sears@barrons.com
http://twitter.com/smsearsBarrons
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