By: Guy Adami, Director, Advisor Advocacy
Published July 26, 2017
It seems like these days, the markets are making new all-time highs. It is seemingly impervious to negative headlines and events that historically would have derailed the moves higher. For further proof, one needs to look only at the CBOE Volatility Index®. Currently we find it within percentage points of an all-time low at $9.60. For context, at the peak of the financial crisis in the fall of 2008, it was trading either side of $80.00. I’m forever in search of explanations for things that don’t make sense to me, and right now the depressed VIX is at the top of my list.
Playing the Options Game, Naked
I have recently come to a conclusion that does make sense to me. The resilience of the market is noteworthy, to say the least. For many years, traders were conditioned to buy options in the forms of puts as protection for their positions and/or portfolios. But with each passing month, as selloffs in the market became less frequent and more shallow, these options were becoming a drag on returns. They began to be viewed as a cost instead of insurance. The mindset went from “I need put protection as a hedge against the next downturn” to “The market doesn’t go down regardless of news flow, so why should I bother?” Now, instead of buying options and spending premium, the pendulum has swung to traders selling options to collect premium. In doing so, they create a synthetic dividend for themselves.
I would submit that selling naked options is one of the riskiest strategies out there. Furthermore, as volatility continues to get crushed, the seller of the option is not being paid close to commensurate fashion for the risk they are taking. Statisticians will tell you that selling naked puts is a strategy that is successful almost 80% of the time. What they won’t tell you or don’t realize is that 20% unsuccessful can wipe out all of your gains or, quite frankly, blow you up entirely.
Bulls Over Bears
In the most recent readings from the American Association of Individual Investors, bearish sentiment fell nearly four points to 25.8—the lowest level since early January. Bullish sentiment rose over seven points to 35.5—the highest level since early May. We are in the midst of earnings season. To the best of my investigative skills, the scorecard looks something like this: On a year-over-year basis, we have seen a little over 13% growth in EPS. On the revenue side, on the same year-over-year basis, we have seen growth of about 5.1%.
At what point do we need revenue growth to catch up to EPS growth? From my vantage point, the chasm between the two continues to expand and is flirting with unhealthy levels. I will be quick to point out that this has been true for quite some time now, and to date the market has not cared. On a larger level, my main concern has been and will continue to be the potential for a central bank misstep. Mario Draghi and the ECB remain terrified of terrifying the markets. Draghi recently said that QE could be increased in size and duration if the outlook for the economy worsens. While that is music to the market’s ears, when do we reach the point of diminishing marginal returns in terms of central bank speak and central bank activity?