Options Prices Righting Themselves

Here's a quick reminder to investors who were bemoaning low options prices as a bad thing: Be careful what you wish for -- you may just get it.

Late last week, the Chicago Board Options Exchange's Volatility Index, or VIX -- one of the gauges of options price levels -- began ramping up for the first time in almost six months. Before Wednesday's 100-point rally in the Dow, in fact, it had risen to 27 from 20 less than 10 days before. And even Wednesday's temporary insanity only sliced 1.6% off the VIX, which traders use to measure worry in the market.

So in less than two weeks, the options prices as reflected by the VIX have gone from being undervalued to being fairly valued, according to hedge fund manager Kyle Rosen of Rosen Asset Management in Southern California. With the twin threats of terrorism in the U.S. and daily exposure of market transgressions allegedly perpetrated by everyone from Dennis Kozlowski to Martha Stewart, the VIX isn't likely to see the low 20s for awhile, Rosen says.

Twentysomething

"It's unlikely to get back into the 20s for a long time. You have to find someone to sell options for it to go down," Rosen says. Strangely enough, while selling call options against stock positions had become fashionable when the VIX was so low and the returns were slight, rising options prices mean that investors are again buying options. And that also is likely to go on for awhile.

"I think what happened is that when the market broke, people realized that while it's nice to have a covered call position, it doesn't protect you that much," Rosen says. It certainly didn't protect them if they were holding shares of Safeway (SWY), which has fallen more than 20% in the last four trading sessions, or Abbott Labs (ABT), which is down 17% just this week. The 5% returns you may have gotten selling call options doesn't feel much like a cushion now that you've fallen out a third-floor window, does it?

The call-sellers who thought they were taking in somewhat healthy premiums for options two weeks ago, now have sellers' remorse, as most options prices are markedly higher.

The interest in puts has become downright fashionable these days. Out-of-the-money put prices are climbing on names ranging from Goldman Sachs (GS) to Fannie Mae (FNM) to Alcoa (AA), according to Lillian Seidman and Michele Skupp at Miller Tabak. And put-buying has spiked on stocks as diverse as Siebel Systems (SEBL) and Clorox (CLX).

The options strategists at Gruntal & Co. suggested in their Wednesday research note that because "emotion has taken over the fundamentals of many good companies," the best way to be long a stock is to "dip a toe in the water with a married put. It defines the risk."

Investors seem to be doing more than that. After three straight days of the equity put/call ratio showing about 9 puts trading for every 10 calls, Wednesday's rally didn't show much of a dropoff. On a day when the market rallied, the equity put/call ratio registered 0.85, showing continued strong interest in puts.

Because these indicators typically are followed by contrarians, who see such high levels as a sign of future rallies, some might interpret this activity as bullish. The wrench in that, despite Wednesday's rally, is that options prices were so low for so long that it may take some time to find some real equilibrium to where these indicators can be effective predictors of broad market performance again.

Anxious Night Watch

Rosen says put-buying now reflects uncertainty about overnight events that could roil the markets and scandals that quickly can do huge damage to single stocks.

Put-buying was heavier than usual in Lehman Brothers (LEH) on Monday and Tuesday, but there was only a smattering of activity on Wednesday. That's likely to be indicative of what the market brings up through the summer -- a season that usually shows little increase in options prices -- as investors buy real hedges on stocks they like or play weakness in the ones they don't.

Strange as it may sound, prices are higher and people are buying instead of selling. In the past few months, wise traders may have been buying puts. They're getting paid well now, but Rosen reckons it now may be harder to express fundamental opinions on stocks via options. The reason: Over the past four or five months, investors didn't have to worry about options prices and volatility measures getting much lower. Now that they're higher, price contraction is the new worry.

But worry is usually good for the investors. It's the wishing that kills them every time.

>To order reprints of this article, click here: Reprints