Time may be ripe to buy low-cost option protection
* Options "fear gauge" near 16, far cry from 48 on Aug. 8, 2011
* Decrease in implied volatility, skew help reduce cost of insurance -SFG
* VIX call options also cheap right now, trader says
By Doris Frankel
Aug 8 (Reuters) - With major stock benchmarks close to four-year highs and the option market's barometer of fear in a summer slumber, strategists say it may be a good time to pick up low-cost portfolio insurance for the year-end.
The summer months are often a slower period, when many traders head for the beaches and volatility typically wanes before the historically volatile months of September and October.
This is often reflected in the CBOE Volatility Index or VIX, which tracks projected near-term stock market volatility embedded in a strip of S&P 500 Index options and generally moves inversely to the S&P benchmark.
The options fear gauge on Wednesday was currently hovering around 16, at the lower end of its range since June as the S&P was within striking distance of the 1,422 multiyear high set in April.
"Now is a good time to buy downside puts on the S&P 500 index because they can increase in value if the market falls and if volatility moves up," said WhatsTrading.com options strategist Frederic Ruffy.
The current volatility reading on the VIX is a far cry from a year ago on Aug. 8, when the index hit a high of 48 after Standard & Poor's deemed that the United States no longer deserved its AAA credit rating after the close of trading on Aug. 5, 2011.
"A similar trade would be to buy VIX call options which are also cheap right now," said Bill Luby, a private investor who writes the "VIX and More" blog in San Francisco. "VIX call options will increase in value if the market has a sharp downward correction or investors view there is more risk on the horizon."
Investors appear less concerned now that the second-quarter earnings season has largely passed and the Federal Reserve and the European Central Bank have committed to do what is necessary to prevent further significant economic deterioration, said Philip Saunders, equity derivatives strategist at broker-dealer Topeka Capital Markets in New York.
"This signals an appropriate time to lock in yearly gains and purchase cheap protection against the unknown as it is better to buy protection when you can, rather than when you need to," Saunders wrote in a report on Wednesday.
Through July, the S&P 500 returned about 10 percent, the best first seven months of the year since 2003.
Saunders looked at a number of stocks where the purchase of January puts through year-end was appropriate based on their low implied volatility over the next six months, year-to-date performance and average options volume.
Put options can help investors insure their stock holdings against adverse price swings, while a call option gives the buyer a chance to profit on a stock price rise.
Much to Saunders' surprise, four of the top stocks on his list were in the financial sector. He said six-month implied volatility in Goldman Sachs Group, Wells Fargo & Co , Discover Financial Services and US Bancorp stood at or just above 52-week lows.
"Purchasing protection in these heavy macro-influenced names could make a lot of sense here," Saunders said.
For example, investors could buy January at-the-money $105 strike puts in Goldman Sachs for a premium of $9.30, using Tuesday's closing prices. Purchasing a similar put two months ago would have cost roughly $13, Saunders said.
Derivative strategists at Susquehanna Financial Group also found that the cost of downside put protection in the SPDR S&P 500 Trust is near a five-year low as implied volatility and "skew" - a measure of how expensive downside puts are in comparison to upside calls - have decreased.
Implied volatility, a key component of an options price, measures the perceived risk of future stock movement. The decrease in both these metrics helps reduce the cost of protection, Susquehanna said.
Susquehanna, in a report, noted that a three-month 5 percent out-of-the-money SPY put would currently cost around 180 basis points, near the lowest levels of the last five years. That is down from 300 basis points earlier this year, 600 basis points in fall of 2011 and 1,000 basis points at the peak of the 2008 credit crisis.
"Investors who are fearful of a pullback in equities may wish to take advantage of the decreases in implied volatility and skew through protective put purchases in the SPY," Susquehanna said.
Also known as the Spyders, the exchange-traded fund is viewed as a proxy for the S&P 500 Index. (Reporting by Doris Frankel in Chicago; editing by Matthew Lewis)
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