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Subject Member Profile Date Posted How Heavy Puts and Short Interest Help Support the... qqq bear NEW 7/16/2007 4:40:23 PM Disbelieved for Your Protection A Look Into How Heavy Puts and Short Interest Help Support the Market 7/16/2007 12:23 PM ET
"Bets in the options market against the Standard & Poor's 500 Index have exceeded wagers it will rise by a 2-to-1 margin for a month, the longest since Bloomberg began compiling the data in 1995. That's seen as a warning sign the market is due for a decline of 5 to 10 percent after the S&P 500 rose to two records last week, say managers of almost $1 trillion at Morgan Stanley Global Wealth Management, National City Private Client Group and Russell Investment Group. The Leuthold Group, whose flagship fund has beaten 99 percent of similar funds over the last five years, expects the S&P 500 to slide as much as 19 percent by the end of the year. The options market is 'a bell ringer,' said David Darst, who oversees $728 billion as chief investment strategist at New York-based Morgan Stanley's private banking unit. 'On a short- term basis, the market's ahead of itself and could have a pullback.' Darst, who cashed in some stocks in the past 12 months, said the market could drop as much as 10 percent ... Concern that earnings will slow has undermined some investors' conviction that the bull market will continue, prompting them to buy insurance in the options market ... Investors aren't just using put options to wager against the market. Hedge funds are short-selling S&P 500 futures by the most in three years, New York-based Merrill Lynch & Co.'s Mary Ann Bartels said last week. She cited data from the Commodity Futures Trading Commission, a government agency located in Washington." ----(Bloomberg.com – "Stocks in U.S. Poised for 10 Percent Drop, Options Bets Show" – 7/16/07)
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"The Chicago Board Options Exchange's year-and-a-half old Volatility Index options saw a surge in activity Wednesday [July 11], with more than 322,000 contracts traded, easily topping the previous single-day volume record of approximately 277,000 set May 16. In a news release, the CBOE reported that total volume for VIX options in June was just more than 2 million contracts with an average daily volume of 95,283 contracts. This made the Volatility Index the exchange's second-most active index and the fifth-most active product. 'Clearly, buyers are using [the VIX] as protection,' said Dominic Salvino of Group One Trading LP, the specialist for VIX options at the CBOE ... 'It's used by a lot of people, particularly with our out-of-the-money calls, as protection against a market crash,' Mr. Salvino said" ----(HedgeWorld.com – 7/13/07)
Schaeffer's addendum: Our own Richard Sparks was told about the above referenced Bloomberg article when he appeared this morning on our weekly options segment on Bloomberg Television.
Apparently, the fact that the market is being played very heavily from the put side is being taken as an indication that it is about to tank. And this thinking is reaffirmed in the second piece on the wild popularity of the VIX (VIX: sentiment, chart, options) option contracts, with VIX calls being purchased "as protection against a market crash."
Nassim Taleb in his excellent "Fooled By Randomness" book defines a rare event (such as a stock market crash) as one that is devastating in magnitude as well as unexpected (italics mine). In fact, the reason rare events such as stock market crashes can occur is precisely because they are unexpected. If a crash is expected by a significant constituency of market players, then they will take actions to protect themselves that will ultimately forestall its occurrence. And this is precisely what is happening as players gobble up S&P 500 Index (SPX: sentiment, chart, options) puts and VIX calls.
This market has become "pre-sold" – not just due to the aforementioned activities of option players - but also through the heavy short selling that's taking place in the futures markets and in ETF's and in individual stocks. This means that selling that might normally have occurred on market weakness is now occurring in anticipation of market weakness. And this also means that when the market does weaken, the response is not one of panic that could then feed on itself and potentially cause a crash. Instead, there is a propensity for short covering as players in the extremely crowded short trade take some profits off the table. And this covering activity serves to stabilize the market on weakness. In other words, these players have "protected away" the possibility of the event from which they are supposedly protecting themselves.
Does this mean that the market is totally "crash proof"? Of course not, but any crash would occur for reasons totally outside the realm of the reasoning behind the current protection trade, such as a major terrorist attack on American soil. On the other hand, this market is extremely unlikely to crash due to a subprime implosion or a private equity accident or a dollar freefall or a pop in inflation or interest rates or because it has been so long since there has been a major correction. These rationales for a crash are already baked into the huge "protection cake" that has ironically been created amidst one of the strongest bull markets of all time.
Finally, let's turn back the clock to the period ahead of the 1987 crash. Back then "portfolio insurance" or dynamic hedging was the rage, whereby players had concluded they did not need to hedge or buy puts in advance of a market decline - they would instead buy their protection when and if the market weakened and would add to that protection on further weakness. Of course, the net result of the dynamic hedging mentality was an exacerbation of market weakness as everyone scrambled for protection at the same time - in other words, it was the lack of a protection trade that was the precursor to the crash of 1987. Plus there was a huge bubble in selling put premium, especially on the S&P 100 Index (OEX: sentiment, chart, options) . It was believed that put selling was a form of minting money, as the market would keep rising for years to come. Of course, these put sales (which were essentially bets that there would not be a crash) wiped out many traders in the October decline and exacerbated the crash. Was this 1987 environment the polar opposite of our 2007 environment as regards to crash protection? Do you think?
(One last note – I'm aware that Mary Ann Bartels, who is quoted in the Bloomberg piece, fully appreciates the bullish contrarian implications of the heavy futures short interest.)
(20min delay)