The price of call options has fallen to record lows, which has
created extraordinary opportunities for nimble bulls to take
advantage of potential gains with limited risk.
The options market's mirror image of a stock -- call options
that expire in one month and have strike prices equal to the stock
price -- is at the lowest level since 2002 for the average Standard
& Poor's 500 index stock.
The implied volatility of one-month, at-the-money S&P 500
stocks is 18.6% while that of at-the-money, three-month calls is
22.2%, near the 1990 low of 19%. The low volatility is an anomaly
because three-month calls expire after the November general
election and a rash of market-moving economic data, according to a
study released early Wednesday by John Marshall, a Goldman Sachs
derivatives strategist, and Robert D. Boroujerdi, the co-head of
the firm's equity research.
Many investors buy call options when implied volatility --
essentially the options market's view of a stock's future -- is
unusually low. The Goldman Sachs study suggests investors can earn
returns of 155% to 726% buying three-month calls on top-rated
stocks if those stock prices move halfway to analysts' price
targets.
Consider Boeing (ticker: BA). With the stock at $73.27, compared
to the bank's 12-month price target of $94, investors can a buy
November $80 call for 44 cents, just 0.6% of the price of the
underlying stock. If Boeing's stock rises to $83.64, investors
would realize a 726% return on the money spent to buy the call.
Halliburton (HAL) also offers potentially strong returns for
investors who buy the November $38 call when the stock is at
$35.16. If the stock hits $42.58 -- the six-month price target is
$50 -- investors could realize a 452% return on the 83 cents spent
to buy the call.
Other opportunities exist in other companies assigned Goldman
Sachs' top Conviction List investing rating, including Cisco
Systems (CSCO), VMware (VMW), AmerisourceBergen (ABC), Simon
Property Group (SPG), Pfizer (PFE), Activision Blizzard (ATVI),
Precision Castparts (PCP) and Prudential Financial (PRU).
The potential for triple-digit returns in relatively short
periods has obvious broad appeal. But the market often defies the
clinical rationality of financial models that predict stocks should
trade at a certain price over a certain stretch of time if a
company's future is anything like its past.
The real world is filled with uncertainty and risk. Stock prices
could sharply decline, for example, if the Federal Reserve and
European Central Bank disappoint many investors who now expect them
to yet again intervene in the financial markets in the next few
weeks.
But that also is why equity investors often prefer to replace
stocks that trade near 52-week highs with options, especially when
option prices are depressed, as they are now. That way they only
risk the small price paid for the option rather than the potential
loss on a high-priced stock.
While it would seem natural that stock and option prices would
rise in tandem, they can disconnect when equity prices rise
steadily without investors actively buying defensive put options as
a hedge. The absence of fear -- or the existence of complacency
toward the rally -- mechanically lowers options' implied
volatility.
Computer models that price options begin to assume the future
will be like the recent past. So historical volatility becomes
unusually low, which in turn tamps down implied volatility -- the
key factor in determining options premiums.
We have referred to the unusually low implied volatility levels
as an historical anomaly in the options market. We have recommended
investors buy bullish calls on the Select Sector Financial SPDR
exchange-traded fund (XLF) (see Striking Price, "Bulls Buy Calls on
Financials," Aug. 18), and we have advised hedging portfolios to
preserve strong year-to-date gains amid uncertainty on the economic
policy and political fronts (see "Protect -- or Profit -- From
Market-Moving Events," Aug. 21).
Goldman's recommendation to replace stocks with cheaply priced
options is consistent with these ideas that exploit low volatility
in order to further investors' goal of reducing risk and maximizing
gains. It is a rare opportunity that may not last if volatility
reverts to its norms.
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Comments: steve.sears@barrons.com,
http://twitter.com/sm_sears
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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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