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Options market has eyes on Fed, but more worried about weeks ahead

A general view of the U.S. Federal Reserve building as the morning sky breaks over Washington, July 31, 2013. REUTERS/Jonathan Ernst
A general view of the U.S. Federal Reserve building as the morning sky breaks over Washington, July 31, 2013. REUTERS/Jonathan Ernst

By Doris Frankel

(Reuters) - Many equity options traders appear less worried by the U.S. Federal Reserve's expected announcement on Wednesday of a reduction in its huge economic stimulus program than by Washington's looming debt and budget battles.

Hedges on volatility have been on the rise, but those bets do not look to be specifically tied to the Fed which has warned it will wind down its $85 billion-a-month purchases of bonds if the economy is improving.

Betting on S&P 500 Index options suggests the market doesn't see more volatility coming this week, even though the size of the reduction of the Fed program could be crucial to how it is received in the markets.

"I believe the FOMC announcement will no longer be a big market mover other than in the very short term. I expect the Fed to weaken their economic outlook and only cut QE (quantitative easing) by $10 billion and that is priced into the market," said Jim Brown, editor at optionInvestor.com.

"The bigger issues will be the debt ceiling debate and the budget battle."

The CBOE Volatility Index, a popular gauge of Wall Street anxiety, closed at 14.53 Tuesday, which is historically low and represents expectations for relative calm in markets. The VIX has not traded over 18 since June and 30-day historical volatility for the S&P 500 Index is low at 9.8 percent.

The policy-setting Federal Open Market Committee began its two-day meeting on Tuesday. Many investors expect Fed chairman Ben Bernanke will announce a scaling back of bond purchases to $75 billion a month, while keeping interest rates close to zero.

"It seems like now the market is believing that tapering will be very well managed by Bernanke, that he knows exactly what the market is expecting and that he's not going to disappoint," said Jack De Gan, principal and senior advisor at Harbor Advisory in Portsmouth, New Hampshire.

Near-term S&P 500 index options are pricing in a move for the benchmark by this Friday at the low end of its range over the past year.

With the S&P 500 closing at 1705 in trading on Tuesday, the at-the-money weekly 1705 straddle is pricing in a move of 1.1 percent in either direction by this week's expiration, said Gareth Feighery, a founder of options education firm MarketTamer.com in Philadelphia.

A long straddle combines the purchase of a call and put at the same strike and expiration date and is a bet on volatility.

Derivative strategists at Goldman Sachs Group noted the estimated move for a one-week S&P 500 straddle was 1.2 percent as of September 13, in a report on Monday. They said the implied move is at the low end of its 1 to 3 percent range over the last year.

"It is a sign of complacency among traders that the options market is pricing in a relatively small move when the potential for high volatility looms following Wednesday's (Fed) announcement," said Feighery of MarketTamer.

VOLATILITY BETS

VIX options have become a popular alternative product for hedging portfolios rather than S&P 500 options.

"While SPX hedging flows have been mediocre, VIX call/put ratios are running near multi-year highs under moderate volume," Goldman Sachs said. A buyer of a call option tied to the VIX hopes to guard against a large spike in volatility and a potential pullback in stocks.

According to options analytics firm Trade Alert, VIX call open interest has been on a steady climb since July, compared to VIX put open interest which has been relatively low.

As of Monday, over the past two weeks, 3.51 VIX calls have been bought as a new position versus every one VIX put purchased on the Chicago Board Options Exchange, said Ryan Detrick, senior technical analyst at Schaeffer's Investment Research. The ratio is higher than 85 percent of the readings over the past year.

"Some people appear to be doing some prudent hedging ahead of a potential volatile Fed event," Detrick said.

While that ratio is high, the odd timing of options expirations complicates interpretations. September futures and options tied to the popular VIX Index expire on Wednesday at the opening of trading - and therefore do not cover a reaction to the Fed decision due in the afternoon.

Henry Schwartz, president of Trade Alert, said on Tuesday that 45 percent of the VIX open interest is in the September contracts. Meanwhile, the October VIX contracts, which had also been popular would capture worries related to the budget and debt ceiling battles.

The deadline for funding the U.S. government is September 30, when a so-called "continuing resolution" enacted last March expires. By mid-October or early November, the U.S. Treasury likely will run out of borrowing authority.

A battle over the debt ceiling in 2011 was very costly, resulting in the first-ever downgrade of the U.S. credit rating, and a two-month decline of 12.4 percent in the S&P 500. During that time, the VIX surged, rising as high as 48 at one point. By contrast, this year's high in the VIX is just 21.91.

Excluding September, the VIX October 20 calls have the largest open interest of 233,000 contracts. Over the past two weeks, the largest block trade, excluding September, was the October-November 32.50 VIX call spread.

"The spread involved a roll of a long VIX call position from October to November which illustrates some hedges remain and appear to be longer-term views," Schwartz said.

(Reporting by Doris Frankel and Angela Moon; Editing by David Gaffen and Tim Dobbyn)

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