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AS THE 2006 TRADING YEAR draws to a close, many traders combing through the market are increasingly encountering puts and calls with implied volatility levels that may seem unusually attractive.
But investors are advised to be cautious as they navigate the year-end market because December's well-priced options may prove to be anything but in January.
Market makers routinely lower volatility ahead of three-day holiday weekends to offset "time decay," the loss of options value over time. For dealers who make markets in thousands of options contracts, time decay can be a costly business expense. Anyone who feels "holiday options" look like bargains, must be mindful of "time decay," which could offset the cheap volatility.
The U.S. financial markets, of course, are closed Monday for Christmas, which produces an extra day of decay, as does the New Year's day weekend.
In normal market conditions, discrepancies between historical and implied volatility -- the primary determinants of an options price -- are often indications that the market has improperly priced an options contract. Research often reveals that options dealers failed to factor in some event that may move the price of the underlying stock up or down, which in turn means volatility should be adjusted accordingly.
Indeed, for another example of how options trading may not always be what it appears, consider how recent sessions have been overshadowed by portfolio managers and other institutional investors who actively bought options on exchange traded funds and indexes that expire in early 2007. These actively traded products offer exposure to energy, financials, the Standard & Poor's 500 and Nasdaq-100 indexes.
In the past week, for example, about 125,000 at-the-money January 59 puts were bought by various investors on the Energy Select Sector SPDR ETF (XLE). Other investors bought slightly out-of-the-money January 73 calls on the MSCI EAFE fund (EFA) to gain exposure to international markets. While these trades are consistent with expectations that energy may not be a market leader 2007, and that international market growth will exceed U.S. growth rates, the trading may not be based on fundamentals.
Michael Schwartz, Oppenheimer's chief options strategist, said the activity was likely attributable to tax replacement trades. "ETFs are the only tax-swap candidate left because they're not deemed to be an identical security," he said.
Investors who have losses in individual stocks, but failed to sell those positions by Nov. 30, the last-day of the wash-sale rule, sometimes sell stock and buy options on ETFs that offer exposure to the stock's sector -- especially when options volatility is low. The Chicago Board Options Exchange's Market Volatility Index, or VIX, which is the primary barometer for options prices, remains at historic lows. The VIX was recently up 0.53 at 11.06.
To avoid triggering the wash-sale rule, traders who sell a security to record a capital loss, may not repurchase the underlying security for a period of more than 30 days, before and after selling the security at a loss. Investors who violate the wash-sale rule are prevented from the Internal Revenue Service from taking the tax loss in this calendar year.
Indeed, Schwartz said the old adage about using options to reduce risk -- rather than increase risk -- applies to end of year markets more than ever.
"Everything may not always be what it appears to be," he said, "and buying statistically cheap options may prove to be very expensive in the long run.
(C) Barron's Dec 22'06
But investors are advised to be cautious as they navigate the year-end market because December's well-priced options may prove to be anything but in January.
Market makers routinely lower volatility ahead of three-day holiday weekends to offset "time decay," the loss of options value over time. For dealers who make markets in thousands of options contracts, time decay can be a costly business expense. Anyone who feels "holiday options" look like bargains, must be mindful of "time decay," which could offset the cheap volatility.
The U.S. financial markets, of course, are closed Monday for Christmas, which produces an extra day of decay, as does the New Year's day weekend.
In normal market conditions, discrepancies between historical and implied volatility -- the primary determinants of an options price -- are often indications that the market has improperly priced an options contract. Research often reveals that options dealers failed to factor in some event that may move the price of the underlying stock up or down, which in turn means volatility should be adjusted accordingly.
Indeed, for another example of how options trading may not always be what it appears, consider how recent sessions have been overshadowed by portfolio managers and other institutional investors who actively bought options on exchange traded funds and indexes that expire in early 2007. These actively traded products offer exposure to energy, financials, the Standard & Poor's 500 and Nasdaq-100 indexes.
In the past week, for example, about 125,000 at-the-money January 59 puts were bought by various investors on the Energy Select Sector SPDR ETF (XLE). Other investors bought slightly out-of-the-money January 73 calls on the MSCI EAFE fund (EFA) to gain exposure to international markets. While these trades are consistent with expectations that energy may not be a market leader 2007, and that international market growth will exceed U.S. growth rates, the trading may not be based on fundamentals.
Michael Schwartz, Oppenheimer's chief options strategist, said the activity was likely attributable to tax replacement trades. "ETFs are the only tax-swap candidate left because they're not deemed to be an identical security," he said.
Investors who have losses in individual stocks, but failed to sell those positions by Nov. 30, the last-day of the wash-sale rule, sometimes sell stock and buy options on ETFs that offer exposure to the stock's sector -- especially when options volatility is low. The Chicago Board Options Exchange's Market Volatility Index, or VIX, which is the primary barometer for options prices, remains at historic lows. The VIX was recently up 0.53 at 11.06.
To avoid triggering the wash-sale rule, traders who sell a security to record a capital loss, may not repurchase the underlying security for a period of more than 30 days, before and after selling the security at a loss. Investors who violate the wash-sale rule are prevented from the Internal Revenue Service from taking the tax loss in this calendar year.
Indeed, Schwartz said the old adage about using options to reduce risk -- rather than increase risk -- applies to end of year markets more than ever.
"Everything may not always be what it appears to be," he said, "and buying statistically cheap options may prove to be very expensive in the long run.
(C) Barron's Dec 22'06