Optimism Is Scarce, but So Is Fear

Hopes the market could build on yesterday's rally weren't just taken down a few notches Thursday ... they were dashed to bits on the jagged rocks below.

Rattled by reports of a

Securities and Exchange Commission

investigation (which the SEC said late Thursday has been dropped),

IBM

(IBM) - Get Report

fell 5.4% to a 52-week low of $84.19.

General Electric

(GE) - Get Report

lost 9.3% after its revenue fell

shy of expectations and its first quarterly conference call failed to alleviate investor concerns.

Weighed down by those two heavyweights, the

Dow Jones Industrial Average

fell 2% while the

S&P 500

shed 2.4%. The

Nasdaq Composite

fell 2.4% as

Yahoo!

(YHOO)

shed 16.8%, while a host of telecom and related names tumbled. The Nasdaq Telecommunications Index fell 3.6%.

Despite the extent of the damage -- declining stocks led advancers by about 2 to 1 in both

Big Board

and over-the-counter activity -- and rumors of forced selling by mutual funds due to redemptions, the relative absence of fear was noteworthy. The price of the benchmark 10-year Treasury rose, but just 6/32 to 97 15/32, its yield declining to 5.21%. Similarly, the price of gold rose just 0.2% to $303 an ounce.

Among equity indicators, the Chicago Board Option Exchange Market Volatility Index rose 10.4% to 22.33. But the CBOE Nasdaq Volatility Index rose just 3.8% to 43.67, and the equity put/call ratio was 0.68, indicating more call-buying vs. defensive puts.

"Given the massive rumors and capitulation in the

Nasdaq Telecom Index, I would have thought you'd see the put/call ratio in the high 80s or low 90s and the VXN up 15%," said Keith Keenan, vice president of institutional trading at Wall Street Access and

RealMoney Pro.com's

Put N Call columnist. "There's been a tremendous decline in tech stocks, especially telecom and software, but it hasn't been accompanied by vast put-buying. It's very bizarre."

For example, Morgan Stanley reportedly moved a 27 million-share block of

Nokia

(NOK) - Get Report

at $17.60 for a client -- widely rumored to be Janus Funds. But the kind of defensive put-buying you'd expect when word of such a "distressed sale" hits a stock didn't materialize; Nokia shares fell 5.6% to $17.94.

Of 18,000 open contracts on the Nokia April $20 puts, 4,200 traded today, Keenan noted. About half of the 7,000 open contracts on the $17.50 puts traded.

"That's fairly active, but given what happened in the common

stock, it's unusual to see that kind of option activity," he said. "If people were really scared, they'd be buying puts -- that's what forms bottoms."

There was a lot of talk of today being the "washout" or "capitulation" session that indicates the downturn is about to reverse. Equity futures were solidly higher late Thursday after the news the IBM probe was dropped.

But before that story hit, Keenan was having none of the washout talk, citing the relative absence of put-buyers.

"If you look at the volatility, no one cares about options -- the activity is so dry," he said. "There were no big prints, not even on IBM today, which is very unusual, given the magnitude of the decline."

Volatility in the Eye of the Beholder

Returning to

yesterday's topic about betting on volatility, Keenan said employing straddles -- buying calls and puts on a given stock or index with the same strike price -- is a prudent strategy.

However, he noted a lot of institutions have been selling, or shorting, straddles of late, particularly on tech names such as

Microsoft

(MSFT) - Get Report

,

QLogic

(QLGC)

and

Applied Materials

(AMAT) - Get Report

. The bet that volatility will remain subdued paid off in the first quarter, but "guys have been so successful shorting volatility, they can't see the sentiment has shifted," Keenan said. "Whenever I see a strategy be successful for such a long period, I like to take the other side."

Indeed, the trader believes volatility in tech names is going to increase dramatically short term, with the VXN "going through the roof," the Comp hitting 1600, and Janus "puking up everything." Thereafter, he foresees market players then "crushing the Old Economy names" that have heretofore held up well, and the VIX rising sharply.

But of course, one man's meat is another man's poison.

Jerry Hanweck, head of equity derivatives strategy at J.P. Morgan, believes volatility is expensive (i.e., high) right now and recommends selling it. Like many market veterans he noted that volatility is low only relative to recent history, not to long-term trends.

The S&P 500 is trading with implied volatility of about 19% vs. its long-term history of 17.5%, Hanweck noted.

Software and services are the most expensive sectors in terms of volatility, he said, and within that industry the priciest names are Microsoft,

Adobe Systems

(ADBE) - Get Report

,

Novell

(NOVL)

,

Symantec

(SYMC) - Get Report

and

EDS

(EDS)

.

Microsoft stands out, Hanweck said, because it has already preannounced and it's such a well-heeled firm. The software giant, on which he is short calls and long the common stock, was trading with an implied volatility of more than 40% vs. about 30% in late March, as measured by its at-the-money options. (For those without access to a Bloomberg terminal, information about implied volatility can be found at various Web sites, including CBOT.com and Ivolatilty.com, which requires a subscription.)

If an investor owned the stock and wanted to bet that implied volatility on Microsoft will decline, he could sell calls and earn a 5.7% return in the next month based on current prices if the stock doesn't move much. Such a strategy would cap any upside on the common stock, but the "hefty premium" for selling the call and the potential for that 5.7% return "isn't bad in these markets," he said.

Overall volatility is likely to increase near term as earnings hit full bore, Hanweck continued, but a lot of institutions expect volatility to diminish thereafter during the historically slow summer months.

"If earnings season doesn't kick up volatility, I'm not sure what will," he said. "But outside major geopolitical events, I think there's definitely room for volatility to come down in the summertime."

Given the postclose news on IBM, it certainly appears as if the markets' wild swings will continue short term, even if volatility measures remain subdued.

Aaron L. Task writes daily for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks, although he owns stock in TheStreet.com. He also doesn't invest in hedge funds or other private investment partnerships. He invites you to send your feedback to

Aaron L. Task.