BY GUNJAN BANERJI
Bullish call options on the Euro Stoxx 50 are at their cheapest levels relative to those on the S&P 500 in years.
In an unusual turn of events, shares of European companies have recently outperformed those in the U.S. At the same time, expected swings in European stocks have dwindled relative to domestic ones.
The Standard & Poor’s 500 index is up 3.2% this quarter. The Euro Stoxx 50 index is up 6.2%, after underperforming U.S. equities in recent years.
Think the trend higher in European stocks is here to stay? Bullish call options on the Euro Stoxx 50 are at their cheapest levels relative to those on the S&P 500 in years, according to New York–based brokerage Macro Risk Advisors.
The firm recommends buying call options on European stocks expiring in three months while selling similar options on the S&P 500. Call options confer the right to buy shares at a given price later in time. Such a trade would prove profitable if European shares rallied further. Investors can wager on exchange- traded funds that track European stocks or the index itself.
Historically, investors would have had to pay handsomely to make such a trade, says Pravit Chintawongvanich, a derivatives strategist at Macro Risk Advisors. But the higher expected volatility in the U.S. stock market makes it more profitable to sell the options, helping to finance a bet on European stocks, says the firm.
The Cboe Volatility Index, or VIX, shot up this year and has remained above last year’s historically low average, though market tumult has receded in recent days.
The result? Traders are expecting U.S. stocks to remain more turbulent than European equities—a historical rarity, according to Chintawongvanich. Greater volatility can lead to higher options prices, making selling them on the S&P 500 more profitable.
The intraday moves in the U.S. market have caused a measure of so-called realized market swings to skyrocket, analysts say.
The difference between the volatility that stocks are experiencing on a day-to-day basis and what’s expected in the future has shrunk. This has been reflected in a flatter VIX futures curve in recent weeks, which indicates traders’ expectations of swings later in time relative to near-dated moves.
Investors’ expectation of volatility in U.S. stocks is greater than in European stocks, and so is the level of volatility experienced by domestic stocks.
“Usually global markets are correlated,” says Eric Metz, chief investment officer of SpiderRock Advisors, which focuses on options strategies. “The divergence between the U.S. and Europe right now is statistically significant.”
Metz says U.S. markets are still normalizing after a surge in volatility jolted markets in February.
Large intraday moves for U.S. stocks have become common. Last Monday, for example, the Dow Jones Industrial Average surged more than 200 points before paring much of its gains, as President Donald Trump tweeted that he would release his decision on the Iran nuclear deal the next day.
But there’s one note of caution for options traders. Investors should be wary that European stocks have rallied because of the strengthening dollar, says Chintawongvanich. As the dollar has notched gains against the euro, European stocks have risen. If the greenback’s advance loses steam, that could reverse, he cautioned. Year to date, the dollar is up 1.3% versus the euro.
The soaring dollar even appears to have outweighed some lackluster data stemming from Europe lately, such as German factory orders and European inflation readings, which have fallen short of analysts’ expectations.
“The dollar rally of recent weeks has driven European equity outperformance, even though European economic data has actually surprised to the downside,” says Chintawongvanich. “If the dollar were to reverse, perhaps European equities would give back some of their outperformance.”
Gunjan Banerji covers options and market volatility for The Wall Street Journal.
Source: https://www.barrons.com/articles/riding-european-stocks-higher-1525978895
