A Bet on a Falling Stock Market

A Bet on a Falling Stock Market

By STEVEN M. SEARS | MORE ARTICLES BY AUTHOR


The options market is telegraphing warning signals for the stock market.

Goldman Sachs is telling clients that trading patterns in so-called binary options -- which increase in value should the Standard & Poor's 500 index fall by 10% over the next month -- are telegraphing bearish signals.

(These specialized options contracts are not listed on exchanges but are traded privately among major investors.)

These binary options -- which have only two outcomes – show that the perceived risk of a sharp stock-market decline increased in the past week, according to Goldman's Krag "Buzz" Gregory in a note to clients.

The heightened fear clearly reflects the debt-crisis debate in Washington, which now appears to be averted, and a stream of troubling economic news in recent days.

Many major investors and money managers often hedge their stock portfolios to protect positions. Put options increase in value when stock prices drop.

While most investors buy puts options that trade on exchanges, including the S&P 500 index, or the SPDR S&P 500 ETF Trust (ticker: SPY), institutional investors also can choose from private trading markets operated by major banks.

In these over-the-counter markets that are closed to ordinary investors, banks create financial products that have some, but not all, of the characteristics of exchange-traded options.

Binary options, which Goldman Sachs analyzed to determine the likelihood of a sharp stock-market decline, pay off only if the stock market declines by a certain percentage. Because of this either-or feature, binary options can be less expensive, but just as potent, as options on the S&P 500 index that are traded at the Chicago Board Options Exchange.

The value of over-the-counter trading is high-level information that is cleaner, and more valuable, than other forms of market news that are widely known. Knowing what is happening in the upper echelons of the market lets investors refine their trading strategies.

"The number one investor question we've gotten over the past week has been on estimating the 'optimal hedge' under various market down, volatility up market scenarios in early August if the debt ceiling debate reaches a stalemate and the macro data deteriorates," Gregory says.

Gregory likes hedging with the S&P 500 index options. He likes buying the September 1285 put, and selling the September 1250 put, to create a "put spread" that would increase in value if the index, recently at about 1280, declines. The spread cost $12 when Gregory first modeled the trade.

Though it is clear that the U.S. will not default on its debt payments, thanks to a last-minute debt-ceiling deal from Congress, the September options offer protects against the aftershocks of the debate.

The September put options protect portfolios if bond-rating agencies decide to downgrade the nation's credit rating because the political compromise did not do enough to eliminate the national debt. In addition, the hedge protects portfolios against a potential wave of bearish sentiment that could be unleashed if the market returns to focusing on slowing economic growth.