An Alternative For Measuring Market's Negative Sentiment: What We Found Is Scary

Includes: GLD, SPY, TLT
by: Sebastien Buttet

"OCTOBER: This is one of the peculiarly dangerous months to speculate in stocks. The other are July, January, September, April, November, May, March, June, December, August, and February." - Mark Twain

With the real possibility of the U.S. (and the world economy) leaping into recession before year end - perhaps triggered by the collapse of the Euro currency and the European Union - investors are jittery and three bellwether indicators attest of this nervousness:

  1. VIX: a measure of volatility for the S&P 500 Index (NYSEARCA:SPY) traded above 30 since the beginning of August. Yesterday it closed at 33.38.
  2. iShares Barclays 20+ Year Treasury Bond ETF (NYSEARCA:TLT): Yield on long-dated Treasuries are at record lows, with TLT making a new high for the year at $114.93.
  3. SPDR Gold Trust ETF (NYSEARCA:GLD): Gold still trades near record high levels around $1,800, even though the metal corrected sharply adter the Swiss Franc lost its safe haven status after the SNB pegged its currency to the Euro.

Here we propose a different measure of market's negative sentiment by comparing the value of deep out-of-the-money and at-the-money put options on the S&P 500 Index that expire in 43 days, on October 22, 2011. What we find is downright scary!

At the time of writing:

  1. At-the-money put: SPY with strike price $120 Oct 11 trades between $5.43 (the bid) and $5.44 (the ask)
  2. Deep out-the-money: SPY with strike price $92 Oct 11 trades between $.50 (the bid) and $.52 (the ask).

Not to be too technical, the value of American options - which can be exercised before expiration - is determined by using a binomial tree model that uses the following inputs:

  1. the strike price,
  2. the expiration date,
  3. the prime lending rate,
  4. whether a dividend is paid,
  5. and the implied volatility.

The first four parameters are readily accessible; the last one needs to be measured. Using the quote for the at-the-money put option with a $120 strike price and with a prime lending rate at 4.5%, we calibrate the implied volatility for the index at 34.6%.

Next, we use the same model with the same parameters to calculate the value of deep out-of-the-money put with strike price $92 and the same expiration date. Note that it would take a drop of more than 23% for the S&P 500 Index to reach 920 from current levels. For those familiar with statistics, it is almost a 3 standard deviation event given the implied volatility level.

The binomial model estimates that the $92 put option should trade for 5 cents, whereas it currently trades at more than 50 cents!!

This leads us to conclude that either the puts are grossly mispriced and should be sold (in fact 10 times overvalued if one trusts the binomial model predictions) or the market will go nose diving between now and October 22! We leave it to SA readers and market participants to decide which of the two outcomes is more likely!

Disclosure: I am short TLT and I am short Oct 11 SPY puts.