Markets panic - Option traders diversify | Options Portfolio Management

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Markets panic - Option traders diversify

Option Market Outlook: 15 September 2008

The market took a beating worse than any other since 9/11/2001. The decline across the indexes was triggered by the news over the weekend that Lehman would be filing for bankruptcy protection. The filing was announced on the heels of several other pieces of bad news including a sale of Merrill Lynch to Bank of America and more record cash injections from the Fed. This has a couple of affects on the market. First, traders will be pushing the market down and risk levels (as indicated by the VIX) are through the roof. This makes long options more expensive than normal and reestablishes a downside bias for most investors.

To a great extent the VIX measures the rise in premiums in options on the S&P 500 index (SPX) and is a very good measure of investor fear. The one caveat we need to note about this rise in investor fear is that today's movements took the index into the extreme range above 30, which is unusual and generally the market doesn't stay up here for long. Traders that are short the market may be well-served to look for ways to mitigate some of their exposure if we start to see a consolidation in the near term.

- To learn more about the VIX check out this video.
- To see how the VIX can affect option premiums click here to see a video.

Preview: 16 September 2008
Besides more news from the banking sector we will see the US Federal Reserve release its monetary policy statement tomorrow. Considering the amount of cash the Fed had to release into the market today to keep the Fed Funds Rate low it seems even more unlikely we will see a rate cut but the language of the release itself could be extremely disruptive for the trend. If the comments from the Fed are very dovish (indicating a likelihood for a rate cut in the future) traders will continue to push the market down because lower rates are usually seen as a sign of economic weakness. Conversely, the Fed may surprise to the upside so that rates can begin to appreciate to levels that would be more expected considering the high levels of economic risk.

Either way the events this week look to be unprecedented in the last several decades. The market will likely continue to experience significant levels of volatility and losses in concentrated investments in a single stock option should be considered less desirable to a diversified portoflio of options or options on diversified ETFs. Click here to see today's video with more details about what it going on now in the market and what options traders can do about it.

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