Lackluster Week for Equity Implied Volatility - VIX Cheap
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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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Lackluster Week for Equity Implied Volatility - VIX Cheap Document Transcript

  • 1. September 5, 2006 Index Volatility Commentary Ryan Renicker, CFA 1.212.526.9425 • The end of summer saw yet another lackluster week for equity volatility, with the last two weeksryan.renicker@lehman.com being the quietest this year. Devapriya Mallick 1.212.526.5429 • Last week, the cheapening of front month implied vols was led by smallcaps, which is not dmallik@lehman.com surprising in light of their 2.2% outperformance over largecaps. • The last 3 weeks have seen signs of another smallcap rally after their middle of August troughs, accompanied by a rally in higher beta industry groups within the S&P 500. • However, the smallcap vol compression is at odds with the bid for higher quality assets in credit markets. • Lehman’s Global Equity strategists have highlighted that largecap valuations look extremely cheap relative to smallcaps. A bullish long-term stance on largecaps combined with the cheapening in smallcap vols should increase the marginal propensity to use puts on smallcap indices as a means of portfolio protection.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 Largecaps vs Smallcaps - A Closer Look The end of summer saw yet another lackluster week for equity volatility, with the last two weeks being the quietest this year for broad market indices. Wednesday and Thursday saw trading in an extremely tight range (Thursday’s high-low range was the smallest for the year) as investors held back ahead of Friday’s employment report, and a non-farm payrolls number in line with consensus was not a significant catalyst at the end of the week. Consistent with the gamma evaporation, front month vols have cheapened and term structures have steepened, a trend led initially by largecaps. Last week, the cheapening was led by small cap vols and IWM1 1-month implied vol finished more than 1% lower while 1-month implied vols for OEX2 were almost flat (Figure 1). This is not surprising considering the 2.2% outperformance of the IWM relative to the OEX. A closer look at regression expectations using weekly returns vs changes in 1-month implied vol since 20033 reveals that last week’s drop in the IWM-OEX ATM implied vol spread is in line with the historical drop following similar smallcap rallies relative to largecaps (Figure 2).Figure 1: Smallcap Vols Cheapened Relative to Largecap… Figure 2: … As Expected Given Last Week’s Outperformance 8% 4% Weekly Change in IWM-OEX Vol Spread 3% 6% Weekly 1m Implied Vol Change (OEX) Weekly 1m Implied Vol Change (IWM) 2% 4% 1% 2% 0% -1% 0% -2% -2% y = -0.4284x + 0.0015 -3% R2 = 0.2719 -4% -4% -5% -6% -6% ul 04 l an 03 n un un 17 b eb ep 26 y ay 17 r 31 r 13 r ug ug u pr 12 r a a a a e p a -6% -4% -2% 0% 2% 4% 6% -J -J -M -M -M -M -M -A -A -S -J -J -J -J -F -F -A -A 07 21 06 20 09 23 03 28 01 18 Relative 1Wk Return (IWM vs OEX)Source: Lehman Brothers, OptionMetrics Source: Lehman Brothers, OptionMetrics 2006 has been a year when getting the largecap vs smallcap call correct has been more important than the average year. Since the selloff in October 2005, the RTY outperformed the OEX by almost 15% over a 6-month period. Almost all of this outperformance was reversed over the subsequent 3 months (Figure 3). The last 3 weeks have seen signs of another reversal, with the smallcap rally being accompanied by greater demand for other riskier assets. This can be seen by the outperformance of higher beta industry groups within the S&P 500 over the same period (Figure 4). 1 We consider IWM implied volatility as a proxy for the RTY because of greater option liquidity. 2 Using OEX returns and implied vols permits us to isolate the behavior of the larger cap names within the S&P 500. 3 Note that while the regression between vol spreads and relative returns of two indices is not as strong as that between weekly returns and weekly vol changes for a single index, it still results in a reasonable fit. September 5, 2006 2
  • 3. Equity Derivatives Strategy | Index Volatility CommentaryFigure 3: Signs of the Oct-May Smallcap Rally… Figure 4: …Consistent With Recent Bid For Higher Beta Sectors… Beta vs Return Return ( Return 130 GICS Industry Group SPX (04- (3Jan - 5May - (11Aug- Smallcaps outperformed by OEX 125 about 15% till early May 05) 5May) 11Aug) 1Sep) RTY S&P 500 Industry Groups With Lowest Betas (2004-2005) 120 Food, Beverage & Tobacco 0.66 3.5% 5.2% 3.3% Household & Personal Products 0.71 -1.5% 4.6% 2.9% 115 Utilities 0.77 -0.1% 5.3% 2.4% Food & Staples Retailing 0.80 2.6% -0.6% 2.7% 110 Pharmaceuticals & Biotechnology 0.82 -0.7% 3.0% 4.2% 105 S&P 500 Industry Groups With Highest Betas (2004-2005) Semiconductors & Semiconductor Equipment 1.50 -3.7% -18.3% 11.3% 100 Reversed almost Technology Hardware & Equipment 1.27 9.2% -15.9% 10.7% all of it by mid Aug Automobiles & Components 1.25 2.0% 5.5% 4.2% 95 Materials 1.22 11.9% -11.3% 4.6% Retailing 1.21 5.3% -11.4% 2.3% 06 6 06 06 5 5 06 6 5 06 06 l-0 -0 -0 -0 -0 - n- n- b- g- r- ov ec ay ar ct Ju Ja Ju Fe Ap Au O M N D MSource: Lehman Brothers, Bloomberg Source: Lehman Brothers, Bloomberg However, the small cap vol compression relative to large cap vols is at odds with the bid on higher quality assets in credit markets. Figure 5 plots the spread between the Lehman US Credit Index OAS and the Lehman Corporate High Yield OAS, against the 3-month implied vol spread between the IWM and the OEX. Historically, these two spreads have not been very strongly correlated but they have moved together during the flight to quality over the last few months. The recent break-down of the relationship could be a sign of equity markets pricing in a more conducive investment regime for riskier assets than credit markets. Lehman’s Global Equity strategists have highlighted that largecap valuations based on median forward P/Es are currently at extremely cheap levels relative to smallcaps4 (Figure 6). While such a valuation premium for smallcaps can persist for several years (as in the early 90s), a bullish long-term stance on largecaps combined with the cheapening in smallcap vols should increase the marginal propensity to use puts on smallcap indices as a means of portfolio protection.Figure 5: … But At Odds With Continued Flight to Quality in Credit Figure 6: Valuation Argument Remains Compelling for Largecaps 2.8 14% 3 13% Lehman HY OAS - Lehman US Credit OAS Median Fw d PE 2.5 3m Imp Vol Spread (IWM-OEX) 2.6 IWM-OEX Imp Vol Spread (3m) 12% (Largecap vs Smallcap) 11% 2 OAS Difference 2.4 10% 1.5 9% 2.2 8% 1 Spreads highly correlated 7% 2.0 during period of anxiety 0.5 6% 1.8 5% 0 06 6 06 06 5 06 06 06 06 l-0 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 -0 - n- n- b- - g- r- ec ay ar Ju 19 19 19 19 19 19 19 19 19 19 19 20 20 20 20 20 20 Ja Ju Fe Ap Au M D MSource: Lehman Brothers, OptionMetrics Source: Lehman Brothers Equity Strategy 4 Please see Large-Cap Outperformance, Global Strategy Weekly, August 14, 2006. September 5, 2006 3
  • 4. Equity Derivatives Strategy | Index Volatility CommentaryFigure 7: Macro Volatility Summary S&P 500 Implied and Realized Volatility 20% ETF Rich/Cheap Analysis XLI SOX 15% SMH XLB 10% BKX IBB 5% SPX Implied Vol (3-month) XLF SPX Realized Vol (3-month) XLY 0% RTH 5 6 05 5 06 06 6 06 06 5 6 6 -0 -0 -0 -0 -0 r-0 l-0 XAU p- n- b- n- g- ov ay ec ar ct Ju Ap Se Ja Fe Ju Au O M M N D OSX Implied Volatility History (NDX, RTY) OIH 30% IYR 25% PPH 20% BBH XLE 15% XLU 10% NDX Implied Vol (3-month) -3.0 -2.5 -2.0 -1.5 -1.0 -0.5 0.0 0.5 1.0 1.5 2.0 RTY Implied Vol (3-month) 5% Cheap > > > > > > > > > > > > Rich Imp Rel Spread (Std Devs from Mean) Imp SPX Spread (Std Devs from Mean) 0% Note: For each ETF, we calculate the number of standard deviations by which the current 3-month 5 06 05 5 06 06 6 06 06 5 6 6 -0 -0 -0 -0 r-0 l-0 - n- b- n- p- g- v ay ec ar ct implied-realized volatility spread differs from its 1-year average. We repeat the calculation for the Ju Ap No Ja Fe Ju Se Au O M M D ETF implied vs S&P 500 3-month implied volatility. S&P 500 Put-Call Skew S&P 500 Skew (1-week Changes) 12% 1.0% SPX 1-wk Implied Vol Change (90% Strike) 10% SPX 1-wk Implied Vol Change (100% Strike) SPX 20-delta Skew (3-month) SPX 1-wk Implied Vol Change (110% Strike) 8% SPX 20-delta Skew (1-month) 6% 0.0% 4% 2% -1.0% 0% 7 7 8 06 6 06 7 08 -0 -0 0 -0 0 5 06 05 5 6 06 6 6 06 5 6 6 p- c- n- n- c- -0 -0 -0 -0 0 r-0 0 l-0 ar ec ct - p- n- b- n- g- De De Se Ju Ju ov ay ec ar ct O M Ju Ap D Fe Se Ja Ju Au O M M N D Note: The 20-delta skew is calculated as the difference between the 20-delta put and 20-delta call implied volatililty. Weekly changes of implied volatility at the 90% and 110% strike versus the at-the-money strike are a measure of richening/cheapening of skew. Term Structure of ATM Implied Volatility (S&P 500) 3-month Implied and Realized Correlation (S&P 500) 17% 50% 16% 40% 15% 14% 30% 13% 20% 12% SPX Implied Correlation (3-month) 11% "Last" 1-wk Back 1-mo Back 10% SPX Realized Correlation (3-month) 10% 9% 0% 5 6 05 05 06 06 6 06 06 5 6 6 7 7 8 06 6 6 7 8 -0 -0 -0 -0 r-0 l-0 -0 -0 0 -0 0 -0 -0 p- c- n- b- n- g- p- n- n- ov ay ar ct Ju ar ec ec ec ct Ap De Fe Se Ja Ju Au O Ju Ju Se M M N O M D D DSource: Lehman Brothers, OptionMetrics, Bloomberg, FAME September 5, 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”). 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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. September 5, 2006 5