Random Market Observations - Mar 19, 2013

by Wayne Ferbert on March 19th, 2013

1. Cyprus? Really? We are supposed to believe that a country that 50% of American’s could not identify on a map is supposed to shake our markets? I bet only 10% of Americans even know it is an island!
I think the Bears got out ahead on this one and did a good job at making it a story. I am not, right now, a bear or a bull. But I am more skeptical of market valuation at these levels than optimistic. So, any pull back is an opportunity to put on a new position. Yesterday, the bears gave us Cyprus. I definitely didn’t see that one coming!
2. Market volatility is so low that options continue to trade at levels that we haven’t seen since the beginning of 2007. You can buy the ATM straddle that expires in ONE YEAR in March 2014 for about 12% of the market cost in the S&P500. Remember a straddle is purchasing the call and put in the same strike.
The ATMs for the $SPX in March 2014 are trading at roughly $180 combined.  That is very low. It may not seem low when you figure that your break-even is a 12% move in either direction. But it is historically low. It was closer to 10% just a few days ago when I first saw this trade last week.

A year ago, with the S&P500 trading at $1409, the March 2013 $1400 straddle cost $225 - or 16% of the S&P index. So, you can see that recent history shows that today's 12% cost is really low. In September 2011, you would have paid over 22% for the ATM straddle that expired in one year.
So, with a 12% move required to break even in this trade at expiration, why would you consider it? Because you are not going to hold to expiration! If you think a significant move is coming in the market – but are not sure which direction, you would place this trade.  You would not plan to hold this to expiration – but rather would plan for a spike in volatility with a significant market move in one direction or the other. 

It is a way to bet on an increase in volatility over a constructive time period of your choosing - roughly the next 6 months.
The volatility component inherent in the pricing at $180 is very low right now. But if the market were to move significantly in either direction, you would see a spike in volatility that would really help to drive the option that moved in to the money. And it would also help to ease the loss on the option that moves out of the money.
If you expect a strong move in the market in the next 6 months, you can hardly go wrong with this trade with a targeted exit in roughly 6 months – before the time value depreciation kicks in on the option as it moves closer to expiration.
3. Is capitulation a good sign for this market? Experts will tell you that when one camp – bulls or bears – capitulates in the face of a strong directionally trending market, the direction tends to gather steam. In fact, they will tell you that a market shattering move REQUIRES capitulation.
The last couple of weeks, more and more Wall Street high profile bears have switched to a bullish bias. This week it was Morgan Stanley’s team of economists. Before that, it was Meredith Whitney.
While I believe that a BIG TIME rally (like 20% over 6 months) would require real capitulation, I have a tough time believing this capitulation is well timed. Still feels like a bubble being funded by QE from the Fed. After all, the premium being paid for stocks compared to their forward earnings is the highest premium paid by investors since before the crash in 2008.
However, in the end, the reason the market goes up is only part of the story. And it will only be a story you tell your kids in the future if you participate in it. But if ever there was a time to be hedged, this market right now would be the time.

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