Stock Market Indices Trading in a Very Narrow Trading Range

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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 managers and other active fund managers worldwide. Ryan Renicker, CFA

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Stock Market Indices Trading in a Very Narrow Trading Range

  1. 1. August 29, 2006 Index Volatility Commentary Ryan Renicker, CFA 1.212.526.9425 • Equity markets traded in an extremely tight range last week and 1-month realized vol remainsryan.renicker@lehman.com extremely low across indices, at under 8% for the SPX and about 16% for the NDX. Devapriya Mallick 1.212.526.5429 • This was helped by last week being the lightest week of the year in terms of both cash and dmallik@lehman.com derivatives volumes. • The term structure of large cap vols remains steep with the sell-off in near-dated implied volatility. • Weak housing data brought the spotlight back on homebuilders last week. This group has become more sensitive to shifts in market sentiment around monetary policy, and has realized more volatility than almost any other sub-industry in the S&P 500. • The recent pullback in implied volatility provides an opportunity to purchase cheap protection in the space, ahead of expected future volatility.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. 2. Equity Derivatives Strategy | Index Volatility Commentary All Quiet on the Equities Front Equity markets traded in an extremely tight range last week, with the S&P 500 closing in an average absolute range of approximately 3 points. 1-month realized vol remains extremely low across indices, at under 8% for the SPX and about 16% for the NDX. This has been helped by the lack of activity in markets with investors on vacation. Excluding July 3: • In terms of equity volumes on the NYSE, the last 6 trading days are among the 7 lightest days for the year so far. • Last week, average single stock option volume (for constituents of the S&P 500) was lower than in any other week of 2006. Short-dated implied vols have been under pressure and term structures have steepened, especially for largecaps. Yet investors who bought front month options after the cheapening would not have managed to compensate for their decay and our long gamma position from two weeks back has taken a fair amount of pain. We recommend holding on to the position as sufficient catalysts remain for higher realized vol once market activity picks up after the holiday season. The relentless beating down of large cap vols also means that October and December vols still look extremely cheap. 37% of S&P 500 companies (by weight) are scheduled to report earnings before the October expiration yet SPX ATM Oct implieds trade around 11%. The December expiration covers an entire earnings cycle and 3 FOMC decisions, and these are trading at under 12%. Either expiration looks attractive on a hedged basis or as a means of obtaining downside protection in a market trading at the higher end of its range since May.Figure 1: Lightest Week of the Year For Cash and Derivatives… Figure 2: … Kept Implied and Realized Vols Subdued 7.0 2.0 30% Stock Option Volume (Mn Contracts) 6.0 NYSE Equity Volume (Bn Shares 25% 1.5 5.0 20% 4.0 1.0 3.0 15% 2.0 0.5 10% Stock Option Volume (SPX Constituents) 1.0 Equity Volume (NYSE) 5% 0.0 0.0 l ul ul ul ul g ug ug ug Ju Au -J -J -J -J -A -A -A 3- 10 17 24 31 26 ay ay 3 1 ar 14 ar 17 ar ug 28 r pr 17 b 18 g 7- 4- l 20 n an 23 n un 21 l eb Ju u 14 21 28 p Au Ja Ju Fe M -M -M -J -A -A -M -M -A -J -J -F 7- 6- 3- 9- 3- SPX 1m Implied SPX 22d Realized NDX 22d Realized 12 Week Ending NDX 1m Implied IWM 22d Realized IWM 1m ImpliedSource: Lehman Brothers, OptionMetrics Source: Lehman Brothers, OptionMetrics, FAME Homebuilders – More Uncertainty Ahead The housing market was in the spotlight again last week, with both Existing Home Sales and New Home Sales recording month on month decreases of over 4%. This was the largest simultaneous drop in both indices this year and provided further confirmation of a housing slowdown. Macro indicators paint a gloomy picture for homebuilders. Monthly sales are off 10-20% from their peaks and unsold homes’ inventory is increasing as home prices begin to flatten (Figure 3). August 29, 2006 2
  3. 3. Equity Derivatives Strategy | Index Volatility Commentary In a data-dependent environment, shares of homebuilders have been more sensitive to shifts in market sentiment around monetary policy, as seen by the increasing betas relative to the S&P 500 (Figure 4).Figure 3: A Gloomy Macro Picture for Homebuilders1… Figure 4: … And Higher Betas2 in a More Rate-Sensitive Market Last Month of % off % Change 4.0 Indicator Value Peak/Trough Peak/Trough YoYExisting Home Sales Total 6.33 Jun-05 -12.9% -11.2% 3.0Existing Home Sales Months Supply 7.3 Jan-05 97.3% 58.7% Homebuilders - Beta vs SPXExisting Home Sales Median Price 230 N/A N/A 0.9%Pending Home Sales 113.9 Aug-05 -11.2% -9.4%New Home Sales 1072 Jul-05 -21.6% -21.6% 2.0New Home Sales Months Supply 6.5 Aug-03 85.7% 54.8%New Home Sales Median Price 230 Apr-06 -10.5% 0.3%Housing Starts 1795 Jan-06 -20.8% -13.3% 1.0Homebuyer Affordability Index 103.7 Feb-03 -27.6% -7.8%Total Residential Construction Spending 650,785 Dec-05 -3.5% -0.6%Private Residential Construction Spending 641,602 Dec-05 -3.6% -0.8% 0.030-year Mortgage Rate 6.38 N/A N/A N/A 6 6 06 6 06 06 6 06 -0 -0 r-0 l-0MBA Purchase Index 382.2 Jun-05 -27.8% -18.8% b- g- n- n- ay ar Ju Ap Au Ja Ju Fe M MOFHEO House Price Index 393.78 N/A N/A 8.6%Source: Lehman Brothers, Bloomberg Source: Lehman Brothers, Bloomberg Not surprisingly, short term realized volatility for homebuilders has been among the highest across sub- industries in the S&P 500 (Figure 5). With valuations for the group still some distance from reaching a floor, we expect names in the space to remain volatile with short-term risks to the downside. Historically, homebuilders have been particularly sensitive to Fed actions. Since 1989, the group has outperformed the S&P 500 by an average of 26% (not annualized) during easing cycles and underperformed by about 26% during tightening cycles (Figure 6). While implied vols for the group have risen alongside the selloff, the recent pullback provides an opportunity to purchase protection. Continued uncertainty around any remaining hikes in the current cycle and speculation around any subsequent eases should keep vols bid in this space.Figure 5: … Makes Them the Second Most Volatile Sub-Industry Figure 6: Homebuilders Historically Sensitive to Monetary Policy Realized Realized 10000S&P 500 GICS Sub-Industry Volatility (22- Volatility (66- Easing Easing Tightening -12% -35% day) day) +51%Photographic Products 58.5% 41.9% 1000 TighteningHomebuilding 38.8% 38.3% -39%Home Entertainment Software 37.2% 32.9% EasingTires & Rubber 37.2% 31.5% +49% 100Wireless Telecommunication Services 36.7% 26.5% EasingElectronic Equipment Manufacturers 34.6% 33.4% Easing +5% Tightening +38%Oil & Gas Drilling 33.7% 37.6% -2%Steel 33.5% 46.5% 10Specialized Consumer Services 33.5% 23.1% 89 91 93 95 97 99 01 03 05 19 19 19 19 19 19 20 20 20Internet Retail 33.4% 58.5% Tightening Easing S&P 500 Homebuilding Subindustry S&P 500Source: Lehman Brothers, Bloomberg Source: Lehman Brothers, Bloomberg 1 We consider troughs for no of months’ supply of new and existing homes. For other indicators, we consider the peak. 2 We caveat that betas calculated using daily returns over a 1-month time frame are not as stable as those using a longer history. Yet they provide a better picture of recent changes in sensitivity to market returns. August 29, 2006 3
  4. 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% RTH IBB 5% SPX Implied Vol (3-month) XLY SPX Realized Vol (3-month) XLF 0% XAU 5 6 05 05 5 06 06 6 06 5 6 6 -0 -0 -0 -0 -0 r-0 l-0 OSX g- p- n- b- n- ov ay ec ar ct Ju Ap Au Se Ja Fe Ju O M M N D OIH Implied Volatility History (NDX, RTY) BKX 30% PPH 25% IYR 20% BBH XLU 15% XLE 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 05 5 06 06 6 06 5 6 6 -0 -0 -0 -0 r-0 l-0 - n- b- n- g- p- ov ay ec ar ct implied-realized volatility spread differs from its 1-year average. We repeat the calculation for the Ju Ap Ja Fe Ju Au Se O M N 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% 10% SPX 20-delta Skew (3-month) 0.0% 8% SPX 20-delta Skew (1-month) 6% -1.0% SPX 1-wk Implied Vol Change (90% Strike) 4% -2.0% SPX 1-wk Implied Vol Change (100% Strike) SPX 1-wk Implied Vol Change (110% Strike) 2% -3.0% 0% 7 7 8 06 6 06 7 08 -0 -0 0 -0 0 5 06 05 05 5 6 06 6 6 5 6 6 p- c- n- n- c- 0 -0 -0 -0 0 r-0 0 l-0 ar ec ct - v- g- p- n- b- n- De De Se Ju Ju ay ec ar ct O M Ju Ap D No Au Se Ja Fe Ju O M M 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 5 06 06 6 06 5 6 6 7 7 8 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- p- n- n- ov ay ec ar ct Ju ar ec ec ec ct Ap Fe Au Se Ja Ju O Ju Ju Se M M N D O M D D DSource: Lehman Brothers, OptionMetrics, Bloomberg, FAME August 29, 2006 4
  5. 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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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. 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