Investors shell out to insure against crash (Financial Times of London)

By Chris Bryant and Michael Mackenzie

Published: October 11 2007 22:05 | Last updated: October 11 2007 22:05

Investors are paying out to insure themselves against the possibility of a US stock market crash in unusual numbers but traders are divided over whether the move means a big fall in equity markets is imminent.

When the credit squeeze hit in mid-August, the spread between the cost of put and call options on the S&P 500 hit its highest level since 2001. Although it has since declined, it has remained at elevated levels, according to Morgan Stanley.

A put gives the purchaser the opportunity to insure against a fall in the market and is the option but not the obligation to sell shares at a specified price and date in the future. A call gives you the right but not the obligation to buy shares, allowing the buyer to position himself in case of a market rise.

William Strazzullo, chief market strategist at BellCurve Trading, said the stock market stood at a crucial juncture with the Dow Jones Industrial Average and the S&P 500 both hitting new highs on Thursday.

“In spite of the talk of recession and less consumer spending, we are back at record highs,” said Mr Strazzullo. “To sit up here is bullish and the clock is ticking for shorts. Either we roll over or set the stage for a bigger push higher.”

Todd Salamone, senior vice-president at Schaeffer’s Investment Research, said: “Everyone is expecting a huge decline.”

But Mr Salamone disputed that a crash was imminent. In 2001, put options became more expensive because the market was already falling, he said, while today, hedge funds were buying large volumes of puts to protect their long positions.

Sellers of puts stand to profit if the market does not fall while buyers lose the premium they paid for their insurance.

Yet rising numbers of traders have been insuring their positions against a fall.

“In recent days, we’ve seen higher demand than usual for put options from small retail and large institutional clients,” said Al Greenberg, head floor trader at the CBOE for BNY ConvergEx. “People are preparing for some kind of down-move.”

The gap between the cost of betting on a fall in the S&P 500 versus the right to buy a stock if the market rises is 7.6 percentage points, well above the median reading of 5.9 percentage points.

The spread hit a high of 8.53 on August 17.

This “implied volatility skew” – which reflects the gap between the price of 6-month puts and calls on a 10 per cent move in the S&P 500, currently not profitable at this stage in their life – remained at elevated levels because investors were cautious, said Carl Mason, chief US derivative strategist at Morgan Stanley.

“Buying options protection is the way to keep yourself long and sleep at night,” he added.

Copyright The Financial Times Limited 2007