Fed Move Slices into Options Prices, At Least for Today

The Fed's dramatic 50 basis point cut in interest rates not only added some rocket fuel to the stock market, it may have brought some relief to options traders who had been besieged by high prices as a result of unusually high volatility. How long it lasts is the big question.

Today's Coverage

Nasdaq Soars on Rate-Cut Euphoria

Fed Move Slices into Options Prices, At Least for Today

Why Did the Fed Cut Rates Today?

Long End of Treasury Market Battered Following Rate Cut

Fed Scorecard

Pulse: Giddy Tech Investors Give Life to Beaten Up Chip Stocks

Before today's rate cut, the Chicago Board Options Exchange Volatility Index had been trending toward the mid-30 level, an area that brought high prices for most options contracts. On Tuesday, the VIX closed at 34.20, but it fell to 28.61 in the wake of the Fed move, a decrease of roughly 16% in the course of slightly more than an hour.

While a declining VIX can make options less expensive, the warning signs around the economy and in the broad equity market may mean options price levels quickly return to inflated territory. Strategists are debating the potential staying power of this afternoon's market love-in made possible by Alan Greenspan .

"It happened so fast, but I think it (the rate cut) has taken out much of the uncertainty," said Michael Schwartz, the senior options strategist at CIBC World Markets. "It may mean we've established a bottom for this market."

The VIX is a result of price movement options on the S&P 100 index options, traditionally the contract of choice for institutional investors. A rising VIX shows a tilt toward put options, because those contracts are used to play downturns or hedge stock positions. The volatility of those options -- essentially the measure of the uncertainty Schwartz mentions -- is often seen as a sign that prices across the broader options market are rising.

Call options on the Nasdaq 100 (QQQ Quote) unit trust attracted heavy action as the Q traded up $7.75 to $61.19 after the cut.

Action in the January 60 calls generated volume of 10,000 contracts as the calls' price rose 3 ($300) to 4 1/2 ($450), a nice year's worth of gains stuffed into 60 minutes of trading. The price of the out-of-the-money January 63 calls popped 2 ($200) to 2 11/16 ($268.75) on volume of more than 5,500 contracts.

The danger in the options market on days when the market moves swiftly and unexpectedly upward is that traders who had sold call options -- meaning they got paid for the obligation of delivering shares -- scramble to buy the calls back at higher prices so they don't have to chase the actual stock in a rising market. These so-called "upside crashes" can catch investors off guard in a market that's expected to be slipping or range-bound.

Still, 1010WallStreet.com options strategist Paul Foster said he's not sold on volatility's remaining low and the long-term effects of the rate cut.

"I'm not sure why the volatility levels have gone down so much," he said. "We have the (December) jobs report coming Friday and earnings season around the corner. I'm not a believer in their staying this low. I could see the VIX tracking back up."

The VIX hasn't been as low as 28 since early December, and reached as high as 34.86 today. Its 52-week low is around 16 and its high is just over 41.