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The market is acting like risk no longer exists, Bank of America says

  • The Dow Jones industrial average, S&P 500 and Nasdaq composite are all up at least 14 percent year to date.
  • But the market has been steadily rising in 2017, with volatility being virtually nonexistent.
  • "At this 30yr anniversary of the '87 crash, the market seems to currently imply there is no way a shock can happen," Bank of America Merrill Lynch's Nikolay Angeloff said.

As stocks have climbed to record levels this year, investors are neglecting one very important aspect of financial markets, according to analysts at Bank of America Merrill Lynch.

That aspect is the existence of risk, said Nikolay Angeloff, equity-linked analyst at Bank of America Merrill Lynch, in a note Tuesday. "The market seems to currently imply there is no way a shock can happen," he said.

"We have now recorded 334 days without a 5% or more pullback, the fourth longest period since 1928," Angeloff said. "If it continues at this pace, it will be the least volatile October in history and third least volatile month ever."

The Dow Jones industrial average, S&P 500 and Nasdaq composite are all up at least 14 percent year to date. But the market has been steadily rising in 2017, with volatility being virtually nonexistent.

The CBOE volatility index, or VIX, has traded around historically low levels and has had five straight weeks in which it closed below 10. The VIX measures the market's anticipated volatility over a 30-day period using a range of S&P 500 options.

Specialist trader Michael Pistillo Jr. wears a dow 23,000 hat, after the dow briefly traded above 23,000, at his post on the floor of the New York Stock Exchange in New York, October 17, 2017.
Brendan McDermid | Reuters
Specialist trader Michael Pistillo Jr. wears a dow 23,000 hat, after the dow briefly traded above 23,000, at his post on the floor of the New York Stock Exchange in New York, October 17, 2017.

"Markets pricing very little potential for a shock seems at odds with still elevated geopolitical and policy risk globally," said Angeloff.

Earlier this month, North Korea Deputy U.N. Ambassador said the situation in the Korean Peninsula has "reached the touch-and-go point and a nuclear war may break out any moment."

In Europe, meanwhile, Spanish Prime Minister Mariano Rajoy moved on Saturday to curtail some of Catalonia's parliamentary powers. Catalonia has been vying to become independent from Spain, and the situation has plunged the country into a geopolitical crisis.

Regardless, U.S. stocks continue to grind higher amid increasing hope that Republicans can move forward with tax reform legislation.

"I can't tell you when this [bull market] will come to an end, but yes, like all things, this too shall end," Gina Sanchez, CEO of Chantico Global, told CNBC on Monday.

"The concern that I have is, if you look at that complacency, it's largely been fed by a huge drop in correlations. Basically, you are just diversifying away all risk, meaning the underlying stocks are much riskier than the aggregate looks like," Sanchez said.

But Angeloff and his team offer an options trade for clients to consider "if you disagree with the
market's implied belief that risk does not exist."

The trade consists of buying near-term at-the-money puts and financing that purchase by selling longer-dated lower strike puts that expire in June 2018. By selling those lower strike puts, the trader in this strategy must be willing to get long the market at that strike price, or in this case 2,275 for the S&P 500.

In other words, this strategy offers near-term protection in exchange for getting long the market at 2,275.

Puts are options that give the owner the right to sell a stock, for example, at a given price within a specific period of time.

Angeloff said buying a hedge against the S&P 500 is at its "most attractive level" in the past 15 years.

— CNBC's Amanda Diaz and Rebecca Ungarino contributed to this report.

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