Volatility a Major Threat to August Stock Prices

CHICAGO – Volatility is starting to stir from its summer slumber as investors bid up options to manage stock market risk before the release of key U.S. economic data and a Federal Reserve policy meeting in early August — catalysts that might unsettle stock prices.

The option market's fear gauge, the Chicago Board Options Exchange's (search) Market Volatility Index or VIX (search), which measures projected volatility embedded in near-term Standard & Poor's 500 options, popped up more than 11 percent to a session high at 11.73 late Friday. Near the close of trading, the VIX was up 10.1 percent at 11.58.

The sentiment indicator had spent most of the month at the bottom of its 15-year range. It fell to a new low of 9.88 last week — a level not seen since 1994 as U.S. stocks rose to four-year highs, lifting investors' spirits.

This high degree of complacency — or optimism — leaves the market vulnerable, analysts say.

"Volatility (the VIX) rose yesterday and is spurting higher today," options analyst Larry McMillan of McMillan Analysis Corp. wrote in a research note sent to clients Friday.

"This is more ominous than any of the other indicators, in my opinion," McMillan continued.

"The last time we saw VIX moving sharply higher without the market dropping much was right at the end of 2004 and that was quickly followed by a sharp decline," McMillan wrote in The Daily Strategist. "So, if the VIX is up again Monday, I'd say it's time to expect that sharp correction we've been leery of."

U.S. stocks fell Friday after a government report showed the economy grew at a rate that matched rather than beat forecasts and crude oil rose slightly above $61 a barrel.

"Investors appear to be relatively encouraged over the recent flood of earnings reports, but now they are turning their attention to the sustainability of corporate growth by looking at macroeconomic indicators," said Herb Kurlan, president of MDNH Partners, a San Francisco-based options market-making firm.

"So in order to protect themselves from disappointing potential economic data in the coming weeks, they are purchasing puts to provide downside protection," Kurlan said. "This has caused the VIX to show some life."

Overall, bullish sentiment remains high, partly due to the relatively upbeat earnings reporting season.

However, a shift in focus to the economy from earnings might add to market volatility, which in turn, can cause great co-movement among stocks, said Frederic Ruffy, an analyst at Optionetics, which provides investment education and analysis services.

Catalysts that could rattle the stock market could come from the key monthly unemployment report (search) next Friday and the Federal Reserve's policy-setting meeting on Aug. 9 on interest rates. The Fed has raised short-term rates nine times since June 2004 in a bid to restrain prices.

"The mixed trading that we often see during earnings reporting season, which leads to gains in some stocks and weakness in others, might be followed by a period when investors buy and sell stocks en masse," Ruffy said. "If so, the market is likely to experience greater daily point moves higher and lower."

With the terror threat possibly adding to uncertainty, energy prices drifting higher, and stocks facing possible competition from higher interest rates, Ruffy noted that early August may be a good time to take advantage of the muted volatility to buy cheap put options for protection heading into the historically volatile months of September and October.

"Considering the very high levels of bullish expectations for the market as reflected in recent option indicators, August may see the start of a sharp retreat to stock prices," said Jay Shartsis, director of option trading at R.F. Lafferty & Co., a brokerage firm specializing in options.