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By Jeff Kearns

May 4 (Bloomberg) — U.S. stocks are rallying the most in seven decades, housing prices are stabilizing and the economy is expanding again after the worst recession since the Great Depression. Yet Dean Curnutt, founder of options advisory and brokerage firm Macro Risk Advisors LLC in New York, is wary.

Curnutt studies the equity options market to gauge traders’ expectations of swings in stock prices, or volatility. He’s concerned because he’s picked up mixed signals in recent months, Bloomberg Markets magazine reports in its June 2010 issue.

On the one hand, the benchmark measure of volatility on short-dated options — the Chicago Board Options Exchange Volatility Index, or VIX — fell in mid-April to where it was before the global credit crisis, indicating that investors weren’t expecting any shocks for equities. At the same time, mounting U.S. debt and questions as to what the removal of government stimulus measures might mean for the recovery indicate that risks to the financial system remain.

That disconnect, Curnutt says, is similar to the one he saw four years ago before stocks peaked, when volatility measures were subdued even as overheated housing prices were creating stresses in the credit markets. Like then, when the euphoria in housing was both propping up stocks and creating longer-term risks, Curnutt is concerned that the forces fueling the current rally — low interest rates and government borrowing to finance stimulus funding — may derail it.

“These structural deficits can’t continue,” says Curnutt, 40, who started Macro Risk Advisors two years ago after working for more than a decade on equity derivatives desks at Lehman Brothers Holdings Inc. and Bank of America Corp. “The alternative is very harsh medicine, spending less and battening down the hatches, which is not good for equity prices.”

Options Shield

Investors can shield themselves from potential tumult in stocks using options, says Curnutt, who set up Macro Risk to advise institutions about equity derivative strategies and to handle trades for clients. Options give the right but not the obligation to buy or sell shares at a set price on or before expiration. Traders use options to guard against price fluctuations, speculate on share-price moves or bet that volatility will increase or decrease.

Thirty-seven years after options appeared on the CBOE, trading has expanded to eight U.S. exchanges and volume has climbed steadily, rising in 2009 to a record 3.61 billion contracts.

Risks in System

Curnutt, leading a staff of eight from Macro Risk’s offices near Manhattan’s Times Square, tracks implied volatility: what options prices are saying about investors’ expectations for market swings. He then combines this information with macroeconomic and financial analysis in a daily report to the firm’s 75 clients, which include hedge funds and pension funds.

“We’re trying to understand where the risks in the system are,” says Curnutt, who monitors relationships between market gauges, including the Standard & Poor’s 500 Index, credit- default swaps, Treasury yields, sovereign debt and oil. “It’s really just trying to figure out where risk may be overpriced or underpriced.”

One place where Curnutt says risk is underpriced is the VIX. Known as the stock market’s fear gauge, the index reflects the cost of using S&P 500 options to protect against equity- market turbulence.

After surging to a record of 80.86 in November 2008 following Lehman’s collapse, the VIX fell more than 80 percent to an almost-three-year low of 15.58 on April 12. The VIX reversed course last week, surging to 22.81 amid debt downgrades of Greece and Portugal. The gauge climbed further today, rising to an almost three-month high of 23.84 as stocks worldwide tumbled on concern that the debt crisis in Europe will spread beyond Greece.

Short-Sighted VIX

For Curnutt, the level of the VIX is misleading — even after today’s gain — because it doesn’t adequately reflect the risks posed by historically low interest rates, growing public debt and the consequences of unwinding government stimulus measures, not to mention the threat of contagion in financial markets from Europe’s debt woes. The VIX only reflects expectations for stock swings during the next 30 days and this year has been further depressed by decreasing volatility, which reduces options prices, he says.

“The VIX isn’t forward-looking,” Curnutt says. He compares April’s levels to those of late 2006, when the index fell below 10 even as “the housing market was crashing and subprime was exploding.”

“Recent history shows us that extremely low volatility can coexist with a market in which systemic risks are very high,” Curnutt says.

Volatility Pattern

These days, near-zero benchmark Federal Reserve interest rates are providing investors with cheap financing while leading them to risky assets such as equities, fueling the stock rally and keeping swings to a minimum. That may change abruptly once the Fed reverses course and starts raising rates, he says.

Curnutt cites the relationship between the real federal funds rate — the Fed’s target rate for overnight lending between banks, adjusted for inflation — and the VIX. During the past 20 years, the VIX has tracked the movements of the real fed funds rate, with a two-year lag. That suggests volatility will increase as the Fed ends its low-rate stance, he says.

Curnutt was introduced to derivatives when he went to work at Nomura Holdings Inc. in New York in 1991 as a research associate after earning a bachelor’s degree in economics from St. John’s University in Queens, New York.

Lehman, BofA

After three years at Nomura, Curnutt went to graduate school at the University of Chicago, receiving his MBA in 1996. He then returned to New York, where he took a job at Lehman structuring equity derivative and swap trades. Four years later, he moved to Bank of America, where, in seven years, he rose to become head of equity sales trading.

By 2007, Curnutt was spending more and more of his time conferring with colleagues specializing in other assets, such as short-term debt and asset-backed bonds. He continued to look at these markets after starting his own firm in 2008.

Curnutt says he’s been focusing this year on gauges of government finances, such as the ratio of total debt to gross domestic product, as well as municipal financing and consumer indebtedness. Those variables will determine how successfully the Fed can end its stimulus programs without roiling global markets.

Curnutt, who plans to hire four traders this year, says trading in options will keep growing as more institutions learn how to use them.

“We’re in the infancy of the product,” he says.

To contact the reporter on this story: Jeff Kearns in New York at

Last Updated: May 4, 2010 16:34 EDT