INTERVIEW: Time to Bet Big on Options by Sandra Ward
- Summary: Interview with J. Kyle Rosen, President, Rosen Capital Management. His fund has enjoyed annual net gains of 8% since its launch seven years ago. Main premise: Regardless of your market outlook (he's bearish; see below), the only way to play it is with options; not the underlying. Reasoning: Historically, implied volatility [IV] has averaged 20%; presently, we hover around 12% — a 40% discount. Yet actual volatility has been creeping up; just when things are getting risky, risk is being massively underpriced. Even if IV only reverts to its mean, lots of money can be made trading options. Methodology: Let's assume a bearish stance. Buy at-the-money S&P 500 put options annualized at 4% (current price). Place your money in short-term Treasuries at 5%, and use the 5% proceeds to pay for your 4% options. Worst-case scenario: The market rallies, and you make 1% — yet you have full coverage to the downside! If your outlook is bullish, do the opposite with calls (calls currently cost about 5% annualized). He stresses the uniqueness of this opportunity: Normally, instead of 4% to 5%, an option would cost from 10% to 13%. Today there is basically no risk premium. Market outlook: • Investors are thinking too short-term, causing them to overlook the broader picture. • The coming midterm election doesn't bode well for the economy: A Democrat win means less-business-friendly tax policies and reduced spending on Iraq. A Republican win will still lead to reduced spending. • The current 15 times P/E index multiple is not cheap; it is historically average. In 1982, 1974 and 1942, we were at seven times earnings. • In the bear market of 2001-2002, investors got burned so badly that they began reassessing stocks as an investment. This was one of the causes of the housing boom; a house or a second home can be enjoyed even if there is a retrenchment, unlike a stock certificate that isn't going up. • If you are going to invest in stocks for the long term, the action continues to be in Asia. • Usually this kind of risk underpricing tells you people are positioned without much hedging and are overleveraged to the upside. • What drives the stock market and the economy the most is the 10-year bond, because that's what mortgages, big-ticket items, and major corporate loans are tied to; if it starts to go the wrong way, there could be an unwinding. • The two most mispriced assets right now are options, which are underpriced, and bonds, which are overpriced.
- Quick comment: The VIX, or volatility index, also known as the "fear index," is presently at all-time lows. Rosen notes that there was some movement in the index during the six-week period from mid-May to the end of June, after which the VIX settled back down to its current lows. Michael Panzer notes that even during that volatile period, the moves were less than impressive — going back to 1990 it doesn't even figure in the top five. This lack of fear, Rosen notes, is reason for concern: Option sellers have set themselves arbitrary targets of 10% to 12% returns a year. With the low VIX, they are forced to take two to three times as much of the same position to target these returns. Conversely, funds are overleveraged and underhedged at a time when liquidity is drying up. Paraphrasing former Fed chairman Alan Greenspan, he says, "the aftermaths of periods of low-risk premiums are usually not very good. The Fed likes to see hedging and battening down the hatches so if there is some sort of crisis, the market can absorb it." Geoff Considine argues that the low VIX readings may signal that the current rally is not being driven by speculative forces but by "real money." He also notes that historically, very low market volatility often signals the start of a bull rally.