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Weakening the Case for a "Summer Volatility Crush"
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Weakening the Case for a "Summer Volatility Crush"

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Actionable trade ideas for stock market investors and traders seeking alpha by overlaying their portfolios with options, other derivatives, ETFs, and disciplined and applied Game Theory for hedge fund …

Actionable trade ideas for stock market investors and traders seeking alpha by overlaying their portfolios with options, other derivatives, ETFs, and disciplined and applied Game Theory for hedge fund managers and other active fund managers worldwide. Ryan Renicker, CFA

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  • 1. August 15, 2006 Index Volatility Commentary Ryan Renicker, CFA 1.212.526.9425 • S&P 500 realized volatility for the 10 trading days in August looks fairly low at about 6%; yet theryan.renicker@lehman.com average daily high-low range is of the same order as in June/July. This indicates market Devapriya Mallick uncertainty is greater than what is captured by the realized volatility calculation. 1.212.526.5429 dmallik@lehman.com • Since the end of World War II, median monthly realized volatility for August has been in line with other months, weakening the case for a “summer vol crush”. • We believe the presence of macroeconomic catalysts could make the late summer more volatile than the last few years. • S&P options expiring in September cheapened about 1 vol pt last week, more than any other maturity. We recommend investors purchase these on a hedged basis to get cheap gamma exposure.Lehman Brothers does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict ofinterest that could affect the objectivity of this report.Customers of Lehman Brothers in the United States can receive independent, third-party research on the company or companies covered in this report, at no cost to them,where such research is available. Customers can access this independent research at www.lehmanlive.com or can call 1-800-2LEHMAN to request a copy of this research.Investors should consider this report as only a single factor in making their investment decision.PLEASE SEE ANALYST(S) CERTIFICATION AND IMPORTANT DISCLOSURES BEGINNING ON PAGE 5.
  • 2. Equity Derivatives Strategy | Index Volatility Commentary Not Quite a Vol Crush For the first 10 trading days of August, S&P 500 realized volatility at about 6% looks extremely low. However, the average daily high-low range in which the S&P 500 has traded – measured as a % of the day’s close – stands at 1%, which is close to the average for June and July (Figure 1). This has two important implications for gamma traders: • Implied vs realized spreads based on very short term realized volatility calculations are likely to look richer than they really are. • For long gamma investors, delta-hedging from close to close would have been a suboptimal strategy over the last 10 days. We take a closer look at the seasonality of realized volatility over the 60-year post World War II period from 1946 to 2005. To lessen the effect of outliers, we consider the median for each month over this period. • We find that October has tended to be the most volatile month while December has been the most range-bound. • S&P 500 realized vol in the summer months has been in line with that of other months (Figure 2), even though August has been a relatively uneventful month over the last 3 years. This would mitigate the argument for a short gamma positioning at this stage in anticipation of a “summer vol crush”.Figure 1: Realized Vol Looks Low Though Uncertainty Persists Figure 2: Seasonality Does Not Justify Selling Gamma 18% 1.4% 13% Monthly Realized Vol (lhs) 16% Avg Daily High-Low Range (% of Close) (rhs) Median Monthly Realized 1.2% Vol (1946-2005) 14% 1.0% 12% 12% 10% 0.8% 11% 8% 0.6% 6% 0.4% 4% 10% 0.2% 2% 0% 0.0% 9% 6 06 6 06 b l 06 6 ar n n v c p ay 06 ct 6 r Ju g l-0 -0 Fe Ap No De -0 Ja Ju Se r-0 Au M O n- n- b- M g- ay ar Ju Ja Ju Fe Ap Au M MSource: Lehman Brothers, Bloomberg Source: Lehman Brothers, Bloomberg August 15, 2006 2
  • 3. Equity Derivatives Strategy | Index Volatility Commentary Economic Releases Continue to be Important The noteworthy macroeconomic event last week was Tuesday’s Fed pause after 17 consecutive hiking decisions since June 2004. Investors had been waiting on the sidelines in anticipation of the decision – last Monday’s NYSE volume was the least in almost a month – and the market rallied about 5 handles following the FOMC meeting, only to reverse within minutes. We examine select economic releases within the last two months to quantify the immediate market reaction to each of these (Figure 3). Given concerns about mounting inflation risks, CPI releases have been relatively important catalysts. For instance, within the first 30 minutes of trading after the July CPI release, the S&P 500 had moved 1% from its previous close. Figure 3: Market Reaction to Select Economic Catalysts SPX Return SPX Return VIX Change VIX Change Date Time Macro Catalyst (first 30 mins) (first 60 mins) (first 30 mins) (first 60 mins) 13-Jun 8:30 PPI 0.2% 0.0% -0.4 0.3 14-Jun 8:30 CPI 0.5% 0.5% -0.8 -1.2 29-Jun 14:15 FOMC Meeting 0.8% 1.1% -2.7 -3.4 7-Jul 8:30 Non Farm Payrolls -0.3% -0.1% 0.3 0.1 18-Jul 8:30 PPI 0.3% 0.1% -0.7 -0.4 19-Jul 8:30 CPI 1.0% 1.1% -2.1 -2.5 20-Jul 14:00 FOMC Minutes -0.4% -0.4% 0.4 0.5 28-Jul 8:30 Q2 GDP 0.7% 0.4% -0.8 -0.6 4-Aug 8:30 Non Farm Payrolls 0.6% 0.6% -0.8 -0.7 8-Aug 14:15 FOMC Meeting -0.3% -0.6% 0.0 -0.1 Source: Lehman Brothers, Bloomberg The economic calendar for this week includes PPI data on Tuesday and CPI on Wednesday. We expect inflation numbers to continue to be significant drivers of market volatility. In this backdrop, we view the 1 vol pt cheapening over the last week in SPX Sep options as unwarranted. ATM implied vol in the Sep line is trading at around 12.8% and has dropped more than any other maturity. We recommend investors purchase hedged options maturing in September to get cheap exposure to potential future gamma. August 15, 2006 3
  • 4. Equity Derivatives Strategy | Index Volatility CommentaryFigure 4: Macro Volatility Summary S&P 500 Implied and Realized Volatility 20% ETF Rich/Cheap Analysis SMH 15% SOX XLB 10% IBB OIH 5% SPX Implied Vol (3-month) OSX SPX Realized Vol (3-month) XLI 0% XAU 5 6 05 05 5 06 06 6 06 5 6 6 -0 -0 -0 -0 -0 r-0 l-0 g- p- n- b- n- BKX ov ay ec ar ct Ju Ap Au Se Ja Fe Ju O M M N D XLY Implied Volatility History (NDX, RTY) 30% IYR XLF 25% RTH 20% PPH 15% XLE 10% NDX Implied Vol (3-month) XLU RTY Implied Vol (3-month) 5% BBH 0% -2.5 -2.0 -1.5 -1.0 -0.5 0.0 0.5 1.0 1.5 2.0 2.5 05 6 05 05 5 06 06 6 06 5 6 6 Cheap > > > > > > > > > > > > Rich -0 -0 -0 -0 r-0 l-0 v- g- p- n- b- n- ay ec ar ct Ju Ap No Au Se Ja Fe Ju O M M D Imp Rel Spread (Std Devs from Mean) Imp SPX Spread (Std Devs from Mean) S&P 500 Put-Call Skew S&P 500 Skew (1-week Changes) 12% 6.0% 5.0% SPX 1-wk Implied Vol Change (90% Strike) 10% SPX 1-wk Implied Vol Change (100% Strike) SPX 20-delta Skew (3-month) 4.0% SPX 1-wk Implied Vol Change (110% Strike) SPX 20-delta Skew (1-month) 8% 3.0% 6% 2.0% 1.0% 4% 0.0% 2% -1.0% 0% -2.0% 06 06 6 7 07 7 08 8 6 5 06 05 05 5 6 06 6 6 5 6 6 -0 -0 -0 -0 -0 -0 -0 -0 -0 0 r-0 0 l-0 g- p- n- n- c ar ec ec ct - g- p- n- b- n- ov ay ec ar ct De Au Se Ju Ju Ju Ap O M Ja Fe Ju Au Se D D O M M N D Term Structure of Implied Volatility (S&P 500) 3-month Implied and Realized Correlation (S&P 500) 16% 50% 40% 15% 30% 14% 20% SPX ATM Implied Vol (Aug-14) SPX Implied Correlation (3-month) 13% SPX ATM Implied Vol (Aug-07) 10% SPX Realized Correlation (3-month) 12% 0% 5 6 05 05 5 06 06 6 06 5 6 6 7 7 8 06 06 6 6 7 8 -0 -0 -0 -0 -0 r-0 l-0 -0 -0 0 -0 0 -0 -0 g- p- n- b- n- g- p- n- n- ov ay ec ar ct Ju ar ec ec ec ct Ap Fe Au Se Ja Ju O Ju Ju Au Se M M N D O M D D DSource: Lehman Brothers, OptionMetrics, Bloomberg, FAME August 15, 2006 4
  • 5. Equity Derivatives Strategy | Index Volatility CommentaryAnalyst Certification:I, Ryan Renicker, hereby certify (1) that the views expressed in this research email accurately reflect my personal views about any or all of the subject securities orissuers referred to in this email and (2) no part of my compensation was, is or will be directly or indirectly related to the specific recommendations or views expressedin this email.To the extent that any of the conclusions are based on a quantitative model, Lehman Brothers hereby certifies (1) that the views expressed in this research emailaccurately reflect the firms quantitative research model (2) no part of the firms compensation was, is or will be directly or indirectly related to the specificrecommendations or views expressed in this research report.Important DisclosuresLehman Brothers does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have aconflict of interest that could affect the objectivity of this email communication.Customers of Lehman Brothers in the United States can receive independent, third-party research on the company or companies covered in this report, at no cost tothem, where such research is available. Customers can access this independent research at www.lehmanlive.com or can call 1-800-2-LEHMAN to request a copy ofthis research.Investors should consider this communication as only a single factor in making their investment decision.The analysts responsible for preparing this report have received compensation based upon various factors including the Firm’s total revenues, a portion of which isgenerated by investment banking activities.Stock price and ratings history charts along with other important disclosures are available on our disclosure website at www.lehman.com/disclosuresAnd may also be obtained by sending a written request to: LEHMAN BROTHERS CONTROL ROOM , 745 SEVENTH AVENUE, 19TH FLOOR NEW YORK, NY10019Options are not suitable for all investors and the risks of option trading should be weighed against the potential rewards.Supporting documents that form the basis of the recommendations are available on request. Please note that the trade ideas withinthis report in no way relate to the fundamental ratings applied to European stocks by Lehman Brothers Equity Research.This material has been prepared and/or issued by Lehman Brothers Inc., member SIPC, and/or one of its affiliates (“Lehman Brothers”) and has been approved byLehman Brothers International (Europe), authorized and regulated by the Financial Services Authority, in connection with its distribution in the European EconomicArea. This material is distributed in Japan by Lehman Brothers Japan Inc., and in Hong Kong by Lehman Brothers Asia Limited. This material is distributed in Australiaby Lehman Brothers Australia Pty Limited, and in Singapore by Lehman Brothers Inc., Singapore Branch. (“LBIS”). Where this material is distributed by LBIS, pleasenote that it is intended for general circulation only and the recommendations contained herein does not take into account the specific investment objectives, financialsituation or particular needs of any particular person. An investor should consult his Lehman Brothers’ representative regarding the suitability of the product and takeinto account his specific investment objectives, financial situation or particular needs before he makes a commitment to purchase the investment product. This materialis distributed in Korea by Lehman Brothers International (Europe) Seoul Branch. This document is for information purposes only and it should not be regarded as anoffer to sell or as a solicitation of an offer to buy the securities or other instruments mentioned in it. No part of this document may be reproduced in any mannerwithout the written permission of Lehman Brothers. With the exception of disclosures relating to Lehman Brothers, this research report is based on current publicinformation that Lehman Brothers considers reliable, but we make no representation that it is accurate or complete, and it should not be relied on as such. In the caseof any disclosure to the effect that Lehman Brothers Inc. or its affiliates beneficially own 1% or more of any class of common equity securities of the subject company,the computation of beneficial ownership of securities is based upon the methodology used to compute ownership under Section 13(d) of the United States SecuritiesExchange Act of 1934. In the case of any disclosure to the effect that Lehman Brothers Inc. and/or its affiliates hold a short position of at least 1% of the outstandingshare capital of a particular company, such disclosure relates solely to the ordinary share capital of the company. Accordingly, while such calculation representsLehman Brothers’ holdings net of any long position in the ordinary share capital of the company, such calculation excludes any rights or obligations that LehmanBrothers may otherwise have, or which may accrue in the future, with respect to such ordinary share capital. Similarly such calculation does not include any sharesheld or owned by Lehman Brothers where such shares are held under a wider agreement or arrangement (be it with a client or a counterparty) concerning the sharesof such company (e.g. prime broking and/or stock lending activity). Any such disclosure represents the position of Lehman Brothers as of the last business day of thecalendar month preceding the date of this report.This material is provided with the understanding that Lehman Brothers is not acting in a fiduciary capacity. Opinions expressed herein reflect the opinion of LehmanBrothers and are subject to change without notice. The products mentioned in this document may not be eligible for sale in some states or countries, and they may notbe suitable for all types of investors. If an investor has any doubts about product suitability, he should consult his Lehman Brothers representative. The value of and theincome produced by products may fluctuate, so that an investor may get back less than he invested. Value and income may be adversely affected by exchange rates,interest rates, or other factors. Past performance is not necessarily indicative of future results. If a product is income producing, part of the capital invested may beused to pay that income. © 2006 Lehman Brothers. All rights reserved. Additional information is available on request. Please contact a Lehman Brothers entity in yourhome jurisdiction.Lehman Brothers policy for managing conflicts of interest in connection with investment research is available at www.lehman.com/researchconflictspolicy. Ratings,earnings per share forecasts and price targets contained in the Firms equity research reports covering U.S. companies are available atwww.lehman.com/disclosures.Complete disclosure information on companies covered by Lehman Brothers Equity Research is available at www.lehman.com/disclosures. August 15, 2006 5