Stock Market Disconnect in Options Reveals Risk (Update1)
By Jeff Kearns
May 4 (Bloomberg) -- U.S. stocks are rallying the most inseven decades, housing prices are stabilizing and the economyis expanding again after the worst recession since the GreatDepression. Yet Dean Curnutt, founder of options advisory andbrokerage firm Macro Risk Advisors LLC in New York, is wary.
Curnutt studies the equity options market to gauge traders’expectations of swings in stock prices, or volatility. He’sconcerned because he’s picked up mixed signals in recent months,Bloomberg Markets magazine reports in its June 2010 issue.
On the one hand, the benchmark measure of volatility onshort-dated options -- the Chicago Board Options ExchangeVolatility Index, or VIX -- fell in mid-April to where it wasbefore the global credit crisis, indicating that investorsweren’t expecting any shocks for equities. At the same time,mounting U.S. debt and questions as to what the removal ofgovernment stimulus measures might mean for the recoveryindicate that risks to the financial system remain.
That disconnect, Curnutt says, is similar to the one he sawfour years ago before stocks peaked, when volatility measureswere subdued even as overheated housing prices were creatingstresses in the credit markets. Like then, when the euphoria inhousing was both propping up stocks and creating longer-termrisks, Curnutt is concerned that the forces fueling the currentrally -- low interest rates and government borrowing to financestimulus funding -- may derail it.
“These structural deficits can’t continue,” says Curnutt,40, who started Macro Risk Advisors two years ago after workingfor more than a decade on equity derivatives desks at LehmanBrothers Holdings Inc. and Bank of America Corp. “Thealternative is very harsh medicine, spending less and batteningdown the hatches, which is not good for equity prices.”
Options Shield
Investors can shield themselves from potential tumult instocks using options, says Curnutt, who set up Macro Risk toadvise institutions about equity derivative strategies and tohandle trades for clients. Options give the right but not theobligation to buy or sell shares at a set price on or beforeexpiration. Traders use options to guard against pricefluctuations, speculate on share-price moves or bet thatvolatility will increase or decrease.
Thirty-seven years after options appeared on the CBOE,trading has expanded to eight U.S. exchanges and volume hasclimbed steadily, rising in 2009 to a record 3.61 billioncontracts.
Risks in System
Curnutt, leading a staff of eight from Macro Risk’s officesnear Manhattan’s Times Square, tracks implied volatility: whatoptions prices are saying about investors’ expectations formarket swings. He then combines this information withmacroeconomic and financial analysis in a daily report to thefirm’s 75 clients, which include hedge funds and pension funds.
“We’re trying to understand where the risks in the systemare,” says Curnutt, who monitors relationships between marketgauges, including the Standard & Poor’s 500 Index, credit-default swaps, Treasury yields, sovereign debt and oil. “It’sreally just trying to figure out where risk may be overpriced orunderpriced.”
One place where Curnutt says risk is underpriced is theVIX. Known as the stock market’s fear gauge, the index reflectsthe cost of using S&P 500 options to protect against equity-market turbulence.
After surging to a record of 80.86 in November 2008following Lehman’s collapse, the VIX fell more than 80 percentto an almost-three-year low of 15.58 on April 12. The VIXreversed course last week, surging to 22.81 amid debt downgradesof Greece and Portugal. The gauge climbed further today, risingto an almost three-month high of 25.67 at 11:27 a.m. New Yorktime as stocks worldwide tumbled on concern that the debt crisisin Europe will spread beyond Greece.
Short-Sighted VIX
For Curnutt, the level of the VIX is misleading -- evenafter today’s gain -- because it doesn’t adequately reflect therisks posed by historically low interest rates, growing publicdebt and the consequences of unwinding government stimulusmeasures, not to mention the threat of contagion in financialmarkets from Europe’s debt woes. The VIX only reflectsexpectations for stock swings during the next 30 days and thisyear has been further depressed by decreasing volatility, whichreduces options prices, he says.
“The VIX isn’t forward-looking,” Curnutt says. Hecompares April’s levels to those of late 2006, when the indexfell below 10 even as “the housing market was crashing andsubprime was exploding.”
“Recent history shows us that extremely low volatility cancoexist with a market in which systemic risks are very high,”Curnutt says.
Volatility Pattern
These days, near-zero benchmark Federal Reserve interestrates are providing investors with cheap financing while leadingthem to risky assets such as equities, fueling the stock rallyand keeping swings to a minimum. That may change abruptly oncethe Fed reverses course and starts raising rates, he says.
Curnutt cites the relationship between the real federalfunds rate -- the Fed’s target rate for overnight lendingbetween banks, adjusted for inflation -- and the VIX. During thepast 20 years, the VIX has tracked the movements of the real fedfunds rate, with a two-year lag. That suggests volatility willincrease as the Fed ends its low-rate stance, he says.
Curnutt was introduced to derivatives when he went to workat Nomura Holdings Inc. in New York in 1991 as a researchassociate after earning a bachelor’s degree in economics fromSt. John’s University in Queens, New York.
Lehman, BofA
After three years at Nomura, Curnutt went to graduateschool at the University of Chicago, receiving his MBA in 1996.He then returned to New York, where he took a job at Lehmanstructuring equity derivative and swap trades. Four years later,he moved to Bank of America, where, in seven years, he rose tobecome head of equity sales trading.
By 2007, Curnutt was spending more and more of his timeconferring with colleagues specializing in other assets, such asshort-term debt and asset-backed bonds. He continued to look atthese markets after starting his own firm in 2008.
Curnutt says he’s been focusing this year on gauges ofgovernment finances, such as the ratio of total debt to grossdomestic product, as well as municipal financing and consumerindebtedness. Those variables will determine how successfullythe Fed can end its stimulus programs without roiling globalmarkets.
Curnutt, who plans to hire four traders this year, saystrading in options will keep growing as more institutions learnhow to use them.
“We’re in the infancy of the product,” he says.
To contact the reporter on this story:Jeff Kearns in New York at jkearns3@bloomberg.net.
Last Updated: May 4, 2010 11:26 EDT