Contrarian Alert
Call buying, low volatility -- signs of a top?


AT A RECENT ROUNDTABLE DISCUSSION, Banc of America Securities asked some investors how volatile they thought the stock market would be next year.

The answers were remarkably consistent, given that they came from nearly 30 different firms and investors. Actual volatility of the Standard & Poor's 500 stock index, they responded, would average 12.6% in 2005 (in other words, S&P 500 readings would fall within a range 12.6% higher or lower than its average roughly two-thirds of the time next year). In comparison, realized volatility of the 500-stock index was about 21.56% in 2001, 25.96% in 2002, 17.04% in 2003 and 11.24% so far this year.

"What is noteworthy is not just that investors think market volatility will be low, but how many of the predictions fall into a very narrow band," says Dean Curnutt, BofA's head of equity-derivative strategy. Nearly three out of every four respondents said realized S&P 500 volatility would fall between 9% and 13%. "There seems to be a great deal of certainty about the uncertainty," Curnutt says.

They were by no means alone, and their view of the S&P 500 hardly extraordinary. Heading into the holidays, implied volatility of nearly every major stock benchmark -- the projected volatility of these indexes as gleaned from their option prices -- had declined uniformly to the lowest levels in years, a sign option traders are anticipating generally silent nights and quiet days in the stock market.

The overall tenor of the option market remains quietly optimistic. For each of the 13 trading days so far this month, investors at the International Securities Exchange had bought two or more new calls for every new put, according to the busy electronic market's ISEE sentiment indicator. That marked the most sustained bullish streak this year. The 10-day moving average for this call-buying gauge has risen steadily to 2.27, compared with less than 1.5 just two months ago, and is at its highest since late 2002, as far back as the data go..

Such high hopes and low risk perception did not escape the notice of contrarians, who believe stock prices peak along with bullish investor sentiment. Strategists continued to remind their clients to take some stock profits or use cheap options to hedge risk. But such advice isn't likely to be widely heeded until investors sense more immediate threats to stocks, and even those who worry that stocks are at a short-term top don't necessarily believe a sharp drop will be next.

Ken Tower, chief market strategist at Charles Schwab's CyberTrader unit, points out how stocks can often hover at a market top longer than they slump at market bottoms. "Bottoms are accompanied by a lot of bad-news-inspired panic selling," he notes. "Market tops tend to drag out" and are often accompanied by a surfeit of good news that inspires peak buying. Case in point? "Most people will remember that the S&P peaked on March 26, 2000, at 1527, but how many remember that it closed at 1520 on Sept. 1, 2000?"

With stock benchmarks near a three-year high, and option prices slumping, a little hedging took place among those who believe that stocks could peak in 2005. As December options traded their final week, some investors sold short-term S&P index calls and call spreads -- likely people who believe stocks are nearing the end of their spirited autumn run. Meanwhile, small stocks had outperformed the broad market this year, and the IWM, or iShares Russell 2000 Index Fund, is up nearly 16% this year. According to Schaeffer's Research, implied volatility of IWM is, at 17%, near a one-year low -- a sign option premiums are historically cheap. IWM puts were moderately active last week, likely as some investors guarded against a pullback should money begin rotating out of these winners in 2005.

"The option market typically prices in the lowest cost of hedging after a stock rally," writes Joanne Hill, a director of equity derivatives strategy at Goldman Sachs. "This means that it is not too early to consider large-cap equity risk management for 2005."

According to Hill, S&P 500 implied volatility has traded below the 14% level only about 5% of the time over the past decade. To be sure, buying portfolio insurance now through June or December carries some risk, since "costs could move even lower if the U.S. equity market continues its upside momentum into January, benefiting from funds flows and a greater risk appetite at the beginning of the new year," Hill notes. "For that reason, we suggest holding back a portion of the total hedge to implement early next year."

Kopin Tan covers the options market for Dow Jones Newswires.