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Should You Be Buying Market Protection?

Monday, August 10, 2015
Money and Markets
You can also access this issue on our website.
Market Players Buy Huge Piles of Put Option Protection ... Should You?
Market Roundup
Dow +241.79 to 17,615.17
S&P +26.61 to 2,104.18
NASDAQ +58.26 to 5,101.80
10-YR Yield +0.063 to 2.238%
Gold +$9.10 to $1,103.20
Oil +$0.91 to $44.78

By Mike Larson

Worried about this market? Today's rally aside, you’re not alone. Big market players are purchasing huge piles of protection — So much so, in fact, that stock market “insurance” is now more expensive than at any time in the last nine years!

That’s the conclusion of this fascinating Bloomberg story I came across today. Its findings stem from research into the relative price of options on the CBOE VIX index.

A little background first, in case you’re not familiar with how the options market works: Options allow you to speculate on the direction of an index, stock, ETF or other asset. They give you the right, but not the obligation, to buy or sell a given underlying investment. That right changes in value along with the value of the investment.

More specifically, “call” options are bets on an increase in the underlying investment. “Put” options are bets on a decline. Calls appreciate in value if the underlying investment surges, while puts climb in value if the underlying investment tanks.

Is it time to buy put options to protect yourself against market declines?

With that in mind, Bloomberg dug into the relative price and volume of calls and puts on the VIX. Turns out investors have snapped up around 5.9 million VIX calls versus only 2 million puts. The cost of calls is far outpacing the cost of puts, too – with calls the most expensive relative to puts than at any time since July 2006.

You probably know that volatility and the VIX index tend to surge when stocks tank. So the fact everyone and his sister is placing huge bets on a rise in volatility means they’re basically betting on a big drop in the S&P 500.

So should you join them? Does the fact everyone is buying protection mean the “smart money” knows the bull market is toast? Or is this a contrary indicator, a sign that sentiment is so bearish, stocks have nowhere to go but up?

Well, if you look back at July 2006, you’ll see that stocks rallied in the wake of all that summer’s put buying. The Dow Jones Industrial Average climbed from around 11,000 to as high as 14,000 a year later. But that was the bull market’s “last gasp.” You probably remember how much it crashed thereafter in 2008 and 2009.

“There are plenty of yellow warning signs out there.”

This time around, there are plenty of yellow warning signs out there. The collapse in emerging markets. The sharp declines in commodities. The increasing struggles we’re seeing in many industry sectors this year, as opposed to last year when the weakness was concentrated in energy.

And it’s pretty amazing that despite all those problems, volatility itself is still very cheap. The VIX index closed today at around 12.2 – a pittance compared with levels it hit in past crises.

I’m not even talking about the sky-high 96 reading we saw in the Great Recession. I’m talking about much smaller spike levels – like the 47 or so we got during the debt ceiling debate in 2011 or even the 20-25 readings we saw in late 2014/early-2015 as energy and emerging markets suffered their first bout of weakness.

So maybe, just maybe, those insurance buyers are on to something. Maybe they can see the writing on the wall, and are prudently reaching for investments that will dull the pain of a decline.

That’s my take anyway. Now I want to hear yours. Do you think volatility is going to keep rising, and the U.S. stock market is going to hit the skids? Or are too many people betting on a decline, and therefore we’re about to see one heck of a rally?

What fundamental development(s) do you think could set off the next big collapse or surge? Definitely let me know what you’re thinking on this important topic at the website.

Our Readers Speak

What’s going on in the economy, and how will the Federal Reserve react? How did the various Republican candidates fare in the most recent debate, and what does that say about where this country is headed? Those are the main topics you were discussing over at the website this weekend.

Reader Bob T. said the Fed can’t afford to raise rates unless the rest of the world is on board too. His take: “No one at the Fed seems to understand that increasing rates when the rest of the world is holding or reducing will result in an even-higher dollar. That will negatively impact exports and U.S. dollar denominated profits from international sales.”

Reader Charles also said the Fed can’t afford to raise rates because the economy isn’t in as good shape as some think. His view:

“I see economic weakness everywhere. Wait ’til the auto sales crash. They have been selling to weak purchasers with electronic disabling devices installed that will enable the lender to render the car undrivable so they can repossess the car when the purchaser defaults. Shades of another bubble.”

Finally, Reader Kirk W. said: “They are truly between a rock and a hard place and that will only hasten the coming chaos! They often ‘play’ with the jobs numbers, and I wouldn’t be surprised to see that number adjusted downward.

“We now have 93.8 million people not in the workforce, with the actual unemployment rate at 23.1%. Raising rates will be a ‘good’ thing for our economy – especially with a national debt nearing 19 trillion?”

Meanwhile, Reader Reality99r took note of which candidates seemed to “win” the debate, and said there was a message there. The comments: “The non-politicians — Trump, Carson, and Fiorino — prevailed. They have obviously tapped into some sort of primordial survival instinct to help deter the decline of our country. Pragmatic bottom line business minds just may be the panacea. Let common sense prevail rather than political correctness.”

But Reader Ted. F. said the field is still too crowded with candidates who don’t have a chance, so paying too much attention now isn’t worth the effort. His observations:

“It sounds, with so many people, more like a circus, a gathering of clowns. Watching the clothes go round in the dryer is likely more interesting.

“When most of the candidates wake up, look in the mirror, and realize they have not even got an ice cube’s chance in Hell and quit, then maybe there could be a serious debate on real issues. Until then, why bother?”

Is Ted on point with regard to the overcrowded field at this point? Is Kirk correct when he says the economy is hurting more than investors realize? Let me know over at the website.

Personally, I believe the persistent, ongoing lack of substantial wage gains is a key problem for the U.S. economy. But I also don’t believe 0%, crisis-era interest rates make sense any more, and that the Fed is a lot closer to starting to take them away than many investors realize. We will see.

Other Developments of the Day

BulletPrecision Castparts (PCP) has been a stock market laggard for months on end. Not today. The shares surged after Warren Buffett’s Berkshire Hathaway (BRK/A) agreed to buy the metal parts manufacturing firm for $37.2 billion. The price represented a premium of around 21% to where PCP shares closed on Friday.

BulletHere come the lawsuits. Several industry groups and states are planning to file legal challenges soon against President Obama’s new power industry regulations. They’ll argue the Environmental Protection Agency overstepped its bounds when it rolled out its new climate change initiatives.

BulletWith U.S. oil production booming, many are questioning why the heck we still have a national ban on exporting crude in most circumstances. The ban dates back to the 1970s-era Arab oil embargo. But with global and domestic oil prices depressed, the energy industry is pushing hard to have the limits lifted – and Congress may finally be ready to act in the next few months. We’ll see if momentum builds for the effort.

BulletViolence continues to bubble up in Turkey amid that country’s increased role in fighting ISIS across its southern border. The American consulate came under fire from two gunmen, while a bombing at an Istanbul police station killed one officer and wounded 10 other people. The iShares MSCI Turkey ETF (TUR) has been one of the worst emerging market investments, given pressure on the economy and currency there.

So what are your thoughts? Did the EPA go too far? Should oil exports be permitted? Is Warren Buffett’s latest move a smart one? Let me and your fellow investors know over at the website.

Until next time,

Mike Larson

Mike Larson
Mike Larson graduated from Boston University with a B.S. degree in Journalism and a B.A. degree in English in 1998, and went to work for There, he learned the mortgage and interest rates markets inside and out. Mike then joined Weiss Research in 2001. He is the editor of Safe Money Report. He is often quoted by the Washington Post, Reuters, Dow Jones Newswires, Orlando Sentinel, Palm Beach Post and Sun-Sentinel, and he has appeared on CNN, Bloomberg Television and CNBC.
The investment strategy and opinions expressed in this article are those of the author's and do not necessarily reflect those of any other editor at Weiss Research or the company as a whole.

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