Last week, the one-month implied volatility of the Standard & Poor’s 500 index registered 8%. It was the lowest level since 1988, when record- keeping began.
This essentially means that the options market expects stocks to remain unchanged over the next month. But it doesn’t mean, as some investors might conclude, that options are signaling that there’s little risk in the stock market.
A more realistic interpretation is that a disconnect remains between broad indexes and individual stocks. For as the broad market inches forward, many stocks are exhibiting extraordinary price movements, or volatility. The challenge is figuring out how to take advantage of this.
One way is to buy inexpensive calls on expensive stocks. Calls are less expensive, by definition, than associated stocks. This arbitrage generally works for anyone who is interested in buying stocks but fears that shares priced near record highs are the working definition of the greater fool theory.
SUSQUEHANNA’S CHRIS JACOBSON recently suggested that investors swap highflying equities for low-priced calls that expire in three months. His stock-replacement candidates include some very hot stocks: McDonald’s MCD 0.3555245730219589% McDonald’s Corp. U.S.: NYSE USD143.96 0.51 0.3555245730219589% /Date(1494018271241-0500)/ Volume (Delayed 15m) : 2402228 AFTER HOURS USD143.75 -0.21 -0.14587385384829119% Volume (Delayed 15m) : 50508 P/E Ratio 26.56088560885609 Market Cap 117163214026.633 Dividend Yield 2.61183662128369% Rev. per Employee 65050.4 More quote details and news » (ticker: MCD), Costco Wholesale COST -1.2332145793368046% Costco Wholesale Corp. U.S.: Nasdaq USD180.2 -2.25 -1.2332145793368046% /Date(1494018000323-0500)/ Volume (Delayed 15m) : 3580294 AFTER HOURS USD180.29 0.09 0.049944506104328525% Volume (Delayed 15m) : 133343 P/E Ratio 33.247232472324725 Market Cap 80084785847.6532 Dividend Yield 1.1098779134295227% Rev. per Employee 555936 More quote details and news » (COST), Walt Disney DIS 0.737609067194387% Walt Disney Co. U.S.: NYSE USD111.99 0.82 0.737609067194387% /Date(1494018223166-0500)/ Volume (Delayed 15m) : 5613148 AFTER HOURS USD112.19 0.2 0.1785873738726672% Volume (Delayed 15m) : 258206 P/E Ratio 20.21480144404332 Market Cap 175787342475.742 Dividend Yield 1.3929815162068042% Rev. per Employee 281759 More quote details and news » (DIS), Apple AAPL 1.6583634750563025% Apple Inc. U.S.: Nasdaq USD148.96 2.43 1.6583634750563025% /Date(1494018000328-0500)/ Volume (Delayed 15m) : 26427840 AFTER HOURS USD149.05 0.09 0.06041890440386681% Volume (Delayed 15m) : 899885 P/E Ratio 17.42222222222222 Market Cap 768775505519.36 Dividend Yield 1.6917293233082706% Rev. per Employee 1894280 More quote details and news » (AAPL), Home Depot HD 0.5617977528089888% Home Depot Inc. U.S.: NYSE USD155.73 0.87 0.5617977528089888% /Date(1494018032090-0500)/ Volume (Delayed 15m) : 2438179 AFTER HOURS USD155.47 -0.26 -0.16695562833108585% Volume (Delayed 15m) : 62457 P/E Ratio 24.144186046511628 Market Cap 186013023604.229 Dividend Yield 2.286007834071791% Rev. per Employee 232993 More quote details and news » (HD) Boeing BA 1.0597039383842246% Boeing Co. U.S.: NYSE USD185.01 1.94 1.0597039383842246% /Date(1494018176512-0500)/ Volume (Delayed 15m) : 2525559 AFTER HOURS USD185.5 0.49 0.26485054861899354% Volume (Delayed 15m) : 111358 P/E Ratio 22.672794117647058 Market Cap 110497576928.694 Dividend Yield 3.0701043186854764% Rev. per Employee 617375 More quote details and news » (BA), JPMorgan Chase JPM -0.1148105625717566% JPMorgan Chase & Co. U.S.: NYSE USD87 -0.1 -0.1148105625717566% /Date(1494018074562-0500)/ Volume (Delayed 15m) : 9276410 AFTER HOURS USD87 % Volume (Delayed 15m) : 159626 P/E Ratio 13.405238828967642 Market Cap 309449219066.156 Dividend Yield 2.2988505747126435% Rev. per Employee 440858 More quote details and news » (JPM), Rockwell Automation ROK 0.9619109102646869% Rockwell Automation Corp. U.S.: NYSE USD156.39 1.49 0.9619109102646869% /Date(1494018125525-0500)/ Volume (Delayed 15m) : 670114 AFTER HOURS USD156.39 % Volume (Delayed 15m) : 39396 P/E Ratio 26.108514190317194 Market Cap 19920140160.5224 Dividend Yield 1.9438583029605474% Rev. per Employee 275395 More quote details and news » (ROK), and other issues that are up more than 20% since mid-November. Options on all of those have three-month implied volatility levels near two-year lows.
A bigger challenge—and opportunity—is finding inexpensive equity options in anticipation of events that could cause stock prices to increase sharply.
FireEye FEYE 3.7815126050420167% FireEye Inc. U.S.: Nasdaq USD14.82 0.54 3.7815126050420167% /Date(1494018000505-0500)/ Volume (Delayed 15m) : 10993910 AFTER HOURS USD14.83 0.01 0.06747638326585695% Volume (Delayed 15m) : 21224 P/E Ratio N/A Market Cap 2539797835.80784 Dividend Yield N/A Rev. per Employee 248237 More quote details and news » (FEYE), for example, recently rose 13% on good earnings. The SPDR S&P 500 Trust SPY 0.3937007874015748% SPDR S&P 500 ETF Trust U.S.: NYSE Arca 239.7 0.94 0.3937007874015748% /Date(1494032400005-0500)/ Volume (Delayed 15m) : 51298209 AFTER HOURS 239.95 0.25 0.10429703796412182% Volume (Delayed 15m) : 10703059 P/E Ratio N/A Market Cap N/A Dividend Yield 1.7240183562786817% Rev. per Employee N/A More quote details and news » (SPY) barely moved on the same day. Prior to the earnings report, FireEye’s implied volatility was below the past year’s average level. Similar juxtapositions exist across the market.
This issue is very much on the mind of Goldman Sachs GS 0.1235712079085573% Goldman Sachs Group Inc. U.S.: NYSE USD226.87 0.28 0.1235712079085573% /Date(1494018033772-0500)/ Volume (Delayed 15m) : 2421232 AFTER HOURS USD226.71 -0.16 -0.07052497024727818% Volume (Delayed 15m) : 14591 P/E Ratio 12.048327137546469 Market Cap 90135236579.4433 Dividend Yield 1.322343192136466% Rev. per Employee 1150870 More quote details and news » derivative strategists Katherine Fogertey and John Marshall. They recently circulated a trading menu identifying situations in which options are seemingly underpricing potential stock moves ahead of earnings reports or analyst-day meetings.
Though we favor taking directional positions when possible, Goldman likes straddling stocks when volatility is low. A straddle entails buying a put and call with similar expirations and strike prices that match the stock’s quote. The bank’s research has shown that nondirectional trading usually pays off, even though buying a put and call is more expensive than, say, just buying a bullish call.
Fogertey and Marshall are telling clients to straddle Allergan AGN -0.12640163098878696% Allergan PLC U.S.: NYSE USD244.94 -0.31 -0.12640163098878696% /Date(1494018119721-0500)/ Volume (Delayed 15m) : 1293457 AFTER HOURS USD244.99 0.05 0.02041316240712011% Volume (Delayed 15m) : 12638 P/E Ratio 6.5474472066292435 Market Cap 82213865386.9629 Dividend Yield N/A Rev. per Employee 872491 More quote details and news » (AGN) and Priceline Group PCLN -0.3538507440811135% Priceline Group Inc. U.S.: Nasdaq USD1903.65 -6.76 -0.3538507440811135% /Date(1494018000367-0500)/ Volume (Delayed 15m) : 573474 AFTER HOURS USD1906.65 3 0.15759199432668822% Volume (Delayed 15m) : 6801 P/E Ratio 44.61331146004218 Market Cap 93934857882.55 Dividend Yield N/A Rev. per Employee 580703 More quote details and news » (PCLN), ahead of their Tuesday earnings releases. They also like straddling Kohl’s KSS 1.9567979669631512% Kohl’s Corp. U.S.: NYSE USD40.12 0.77 1.9567979669631512% /Date(1494018182744-0500)/ Volume (Delayed 15m) : 3756615 AFTER HOURS USD40.23 0.11 0.2741774675972084% Volume (Delayed 15m) : 31647 P/E Ratio 12.838810841946943 Market Cap 6782208447.48535 Dividend Yield 5.483549351944167% Rev. per Employee 135406 More quote details and news » (KSS), ahead of the retailer’s Thursday earnings report.
Though Goldman is bearish on Kohl’s over the next year, Lindsay Drucker Mann, the bank’s retail analyst, sees “upside risk” in first-quarter estimates, based on easy year-earlier comparisons and Kohl’s opportunity to deliver better sales and merchandise margins.
When the stock was at $39.16, the strategists liked buying Kohl’s May $39 straddles that expire May 12. They told clients the straddle was attractively priced, compared with historical stock moves in reaction to earnings.
The risk, of course, is that the stock moves less than the cost of the straddle. If that happens, the trade fails.
Bottom line: Low volatility, realized and implied, remains one of the central facts of the options market. Many options are priced without the usual fear or greed premium, and this creates opportunities for investors. Everything else is just commentary.
STEVEN SEARS is the author of The Indomitable Investor: Why a Few Succeed in the Stock Market When Everyone Else Fails.
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