Options Strategy Monthly - 2006 - Low Volatility in the 7th Inning? Housing Market, Credit Markets Say "NO"!

780 views

Published on

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

Published in: Economy & Finance, Business
0 Comments
2 Likes
Statistics
Notes
  • Be the first to comment

No Downloads
Views
Total views
780
On SlideShare
0
From Embeds
0
Number of Embeds
16
Actions
Shares
0
Downloads
32
Comments
0
Likes
2
Embeds 0
No embeds

No notes for slide

Options Strategy Monthly - 2006 - Low Volatility in the 7th Inning? Housing Market, Credit Markets Say "NO"!

  1. 1. January 10, 2006 Options Strategy Monthly: Low Volatility in the 7th Inning? Ryan Renicker, CFA Low Volatility Environment Continued in 2005. In 2005, the S&P 500 was largely range- 1.212.526.9425 bound, resulting in the continuation of the nearly 3-year low volatility regime. Although the 12-ryan.renicker@lehman.com month minus 3-month term spread remained positive, the Q4 market rally, accompanied by the Devapriya Mallick substantial decline in short-dated volatility at the end of the year led the term spread higher. This 1.212.526.5429 relatively steep term spread could be a signal that the options market is pricing in higher short- dmallik@lehman.com dated implied volatilities during the following year. Volatility Trading Environment in 2005. Call overwriting continued to be an increasingly popular strategy. This year, the BXM performed roughly in-line with the S&P 500 Total Return Index. Systematically selling volatility was a more difficult strategy in 2005, as implied volatility continued to decline relative to subsequently realized volatility. In October 2005, the CBOE launched options with weekly expirations on the SPX and OEX. “Weeklys” allow investors to trade nearer-term volatility more efficiently than traditional option contracts. Higher Volatility for 2006? We believe both implied and realized volatility for the S&P 500 and single stocks should trade a few volatility points higher in 2006 relative to 2005. Potential catalysts include credit concerns, an uncertain interest rate outlook, housing market weakness, volatile energy prices, reversion in the volatility risk premium, and event risks such as the 2006 U.S. Congressional elections, geopolitical concerns, avian flu, etc. Low Volatility Regime to Continue in 2006? Potential risks to our forecast arise if energy prices stabilize, consumers’ financial condition improves, strength in employment continues, fears of interest rate hikes dissipate, and strong EPS figures and/or multiple expansion allows the S&P 500 to break out of its range. Forecasting Expected Stock Price Moves For Earnings Announcements . We find stocks exhibit average absolute returns of over 3% following earnings reports and their implied volatility gradually rises during the weeks leading up to the announcement. The options market tends to efficiently price in event risks, with higher implied volatility corresponding to stocks that tend to realize relatively large moves following earnings. This was found to be consistent across sectors since the first quarter of 2004. Introducing the Sector Volatility Snapshots. We introduce our Sector Volatility Snapshots, which allow investors to quickly assess aggregate volatility information for each S&P 500 GICS sector. The snapshots will be included in each Options Strategy Monthly, and include implied and realized volatility for each sector and sector-based ETF, along with other useful metrics such as sector put-call skews, sector term structure trends, and notable volatility increases and decreases for stocks within each of the 10 GICS sectors we analyze.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 30.
  2. 2. Equity Derivatives Strategy | Options Strategy Monthly: Low Volatility in the 7th Inning? Table of Contents Volatility Overview: 2005 ..........................................................................................3 Low Volatility Environment Continues: Will the Status Quo Persist? ............................................ 3 Implied Volatility Term Spread and Forward Implied Volatility .................................................. 4 Patterns in Implied Volatility Skew....................................................................................... 5 Volatility Trading Environment in 2005 ..........................................................................6 Call Overwriting Strategies ............................................................................................... 6 Volatility Risk Premium Convergence ................................................................................... 6 Dispersion Trading .......................................................................................................... 7 Options with Weekly Expirations (“Weeklys”)....................................................................... 7 Option Volumes Continue to Accelerate, Currently Stand at Record Levels.................................. 8 Volatility Outlook for 2006 .........................................................................................9 Potential Catalysts for Higher Volatility................................................................................. 9 Low Volatility Regime to Continue in 2006?....................................................................... 11 Earnings Impact on Implied and Realized Volatility .........................................................12 Higher Realized Volatility When Earnings Are Reported ....................................................... 12 Elevated Risk Expectations as Earnings Date Approaches...................................................... 13 Expected Stock Price Reaction to Earnings Announcements ................................................... 14 Event Volatility Predicts Announcement Across Sectors .......................................................... 15 Predictability of Earnings Impact by Quarter ....................................................................... 16 Conclusion .................................................................................................................. 16 Appendix I: Forward Implied Volatility and 1-Day Expected Price Move .............................17 Appendix II: Sector Volatility Snapshots .......................................................................19 January 10, 2006 2
  3. 3. Equity Derivatives Strategy | Options Strategy Monthly: Low Volatility in the 7th Inning? Volatility Overview: 2005 Low Volatility Environment Continues: Will the Status Quo Persist? Throughout the majority of 2005, the S&P 500 Index traded in a relatively tight range, as investors weighed micro factors such as consistently strong earnings growth, against macro and geopolitical concerns, such as rising short-term interest rates and historically high energy prices. These opposing forces tended to partially offset one another, preventing the market from experiencing a strong move to either the upside or downside. This, in turn, resulted in relatively low implied volatility for the S&P 500 for most of the year. In addition, S&P 500 90-day realized volatility averaged a mere 10% for the year. Implied volatility, which tends to trade at a premium to realized, averaged slightly over 12%. In addition, there were three occasions - February, July, and November - when S&P 500 short-dated implied volatility approached 10-year lows. However, credit concerns among U.S. automotive manufacturers took center stage in April, leading (briefly) to widening spreads in credit markets. This credit-driven shock – and accompanying market sell-off – resulted in a temporary spike in short-dated S&P 500 implied volatility, indicating investors were becoming increasingly concerned that credit deterioration could negatively impact the aggregate equity market. This fear quickly subsided, however, and implied volatility retreated from its intra-year high and the S&P 500 rebounded to its multi-year highs. We observed a relatively brief increase in equity risk expectations in October, as investors braced for rd the economic consequences of Hurricanes Katrina and Rita and 3 quarter earnings reports, and anxiously evaluated the degree to which rising interest rates would impact the domestic economic environment. However, heading into November, the market rallied before trading relatively sideways throughout most of December, and implied volatility once again retraced to its multi-year lows. Figure 1: Key Developments in 2005 and their Impact on the S&P 500 and 3-Month Implied Volatility 18% 1,300 SPX at 3 1/2 Auto Woes Drive Interest Rate Fears 17% Year High Credit Spreads and Weigh on Market, 1,280 Vol. Higher Vols. Spike 16% Pre Q3 Earnings 1,260 15% 1,240 Implied Volatility S&P 500 Index 14% 1,220 13% 1,200 12% 1,180 11% 1,160 10% Im plied Vol. Approaches Lack of Catalysts Heading into 9% 1,140 All-Tim e Low s Year End 8% 1,120 5 05 05 05 05 05 05 5 5 5 05 05 l-0 -0 -0 -0 p- - n- n- b- - g- r- ov ec ay ar ct Ju Ja Ju Fe Ap Se Au O M N D M S&P 500 Im plied Volatility (3-m onth) S&P 500 Source: Lehman Brothers, OptionMetrics January 10, 2006 3
  4. 4. Equity Derivatives Strategy | Options Strategy Monthly: Low Volatility in the 7th Inning? Implied Volatility Term Spread and Forward Implied Volatility The term structure of implied volatility and the forward volatility interpolated from longer-dated options can provide insights into how short-dated risk expectations are expected to change in the future. The volatility term spread, measured by the difference between 12-month and 3-month implied volatility, typically moves in inversely with near-term volatility, since longer-dated implied volatility tends to be more stable than shorter-dated implied volatility. In 2005, the 12-month – 3-month term spread bottomed out in April, as investors bid up shorter-term protection during the market downturn associated with widening auto credit spreads. The term spread again narrowed in October as the demand for near-term protection accelerated. Heading into year end, the term spread steepened as near-term catalysts for equity volatility subsided (Figure 2). Figure 2: 12-Month – 3-Month Term Spread 3.0% 1,300 read 2.5% 1,250 erm Sp 2.0% dex 1,200 12 M nth - 3 M nth T S&P 500 In 1.5% o 1,150 1.0% o 1,100 0.5% 12M-3M Term Spread S&P 500 Index 0.0% 1,050 5 05 05 -0 5 -0 5 -0 5 05 l-0 5 -0 5 -0 5 -0 5 -0 n- b- ar pr ay n- ug ep ct ov Ja Fe M A M Ju Ju A S O N Source: Lehman Brothers, OptionMetrics To glean additional information from the term structure, we compare the expected 3-month implied volatility level, in 9 months’ time, (3-month forward volatility in 9 months) with the current 3-month at-the- money implied volatility (Figure 3). While 3-month forward volatility has tended to trade in line with “current” 3-month implied volatility during the past five years (with the exception from mid 2002 to early 2003), we have recently observed the spread between the two metrics widening throughout 2005. We believe this likely indicates the options market is pricing in expectations for higher short- dated implied volatility in the months ahead. Figure 3: 9-Month, 12-Month Forward Implied Vol. vs. 3-Month at-the-money Implied Volatility 40% 9M, 12M Forw ard Implied Vol. 3M Implied Vol. 35% 30% Forw ard 3-M onth Vol. 9-M onths From Now 25% High ve rs us Curre nt 3-Month Vol. 20% 15% 10% 1 2 3 4 5 1 2 3 4 5 l-0 l-0 l-0 l-0 l-0 0 0 0 0 0 n- n- n- n- n- Ju Ju Ju Ju Ju Ja Ja Ja Ja Ja Source: Lehman Brothers, OptionMetrics January 10, 2006 4
  5. 5. Equity Derivatives Strategy | Options Strategy Monthly: Low Volatility in the 7th Inning? Patterns in Implied Volatility Skew Examining changes in the absolute level of at-the-money implied volatility for short-dated options tends to be a common means of estimating risk expectations in the market. However, we believe another useful metric for estimating the degree of market “fear” or “complacency” is the change in the put–call skew, which, compares the relative levels of out-of-the- money implied volatility on 20 delta put contracts with that of 20 delta calls. In Figure 4, we observe two instances when the implied volatility skew experienced rather dramatic increases – once in mid April, and again in mid October – similar to what was observed for at-the- money implied volatility levels. A rise in skew implies investors were likely bidding up downside protection to hedge their existing long portfolios against a possible market downturn. We observed a decline in the demand for downside protection, and perhaps an increased demand for upside exposure in the market during the rally from mid May to the middle of June, as evidenced by the declining put–call skew. A similar trading pattern also occurred during the November rally, as the demand for downside protection subsided when the market rebounded from its late October lows. Figure 4: S&P 500 Index 20 Delta Put – Call Skew (3-Month Constant Maturity Implied Volatility) 7.0% 16% 3-Month 20-Delta Put-Call Skew 6.5% 3-month Implied Vol (RHS) 15% 6.0% 14% 5.5% 5.0% 13% 4.5% 12% 4.0% 11% 3.5% 3.0% 10% 05 5 05 05 05 5 05 5 5 5 05 05 l-0 -0 -0 -0 -0 p- - n- n- b- g- r- ov ec ay ar ct Ju Ja Ju Fe Ap Se Au O M N D M Source: Lehman Brothers, OptionMetrics January 10, 2006 5
  6. 6. Equity Derivatives Strategy | Options Strategy Monthly: Low Volatility in the 7th Inning? Volatility Trading Environment in 2005 Call Overwriting Strategies Call overwriting has become an increasingly popular strategy during the past few years, as investors sought to obtain incremental alpha during the largely range-bound markets of recent years. In an overwrite strategy, an investor holds a long position in a stock or index portfolio and simultaneously writes at-the-money or out-of-the-money calls against the long position. According to the Chicago Board Options Exchange (CBOE), more than $13 billion has recently been allocated by asset managers to buy-write products, many of which are benchmarked to CBOE S&P 500 BuyWrite Index (BXM). During the last five years, the BXM has not only generated additional yield over the S&P 500 (Figure 5), but also displayed relatively lower standard deviation. Of course, the effectiveness of any overwriting strategy largely depends on the direction of the underlying portfolio itself1. Thus, overwriters did not participate in the November market rally, and if going forward the market breaks out of its range, the popularity of the strategy could decline. Figure 5: Performance of Passive Call Overwriting (BXM) vs. S&P 500 Total Return Index 120 110 100 90 80 70 60 Market Rallies, BXM Index Overw riting Underperforms 50 S&P 500 Total Return 40 01 02 03 04 05 0 1 2 3 4 5 -0 -0 -0 -0 -0 -0 n- n- n- n- n- ec ec ec ec ec ec Ju Ju Ju Ju Ju D D D D D D Source: Lehman Brothers, Bloomberg, OptionMetrics Volatility Risk Premium Convergence From a pure volatility trading perspective, the average spread of 3-month at-the-money implied volatility over the subsequent three months’ realized volatility (ex-post realized volatility) can be a useful measure to gauge the premium demanded by option sellers for incurring short volatility risk. This spread traded lower in 2005 than it had in previous years, partly reflecting the growth of strategies that systematically implement net short volatility positions (such as call overwriting funds). 1 Please see Renicker, R.N. and Mallick D. (2005) Enhanced Call Overwriting, Lehman Brothers, Equity Derivatives Strategy, (pages 3, 5 and 9) for further details. January 10, 2006 6
  7. 7. Equity Derivatives Strategy | Options Strategy Monthly: Low Volatility in the 7th Inning? As Figure 6 and Figure 7 demonstrate, the continued compression of the volatility risk premium was witnessed both in options on the S&P 500 Index as well as on single stock options.Figure 6: Volatility Risk Premium (SPX Index Options) Figure 7: Average Implied and Realized Volatility (Equity Options) Average Premium ( 45% Year 3-month Implied - Weighted Average Implied Vol 40% Weighted Average Realized Vol Future Realized) 1996 2.93% 35% Implied Volatility - Ex-Post Realized Volatility 1997 2.21% Dif f erential Approaching Zerio 1998 3.52% 30% 1999 4.89% 25% 2000 -0.61% 2001 2.02% 20% 2002 -1.84% 15% 2003 5.73% 03 04 05 3 4 5 3 4 03 04 05 l-0 l-0 l-0 -0 -0 n- n- n- 2004 4.16% r- r- r- ct ct Ju Ju Ju Ja Ja Ja Ap Ap Ap O O 2005 1.48%Source: Lehman Brothers, OptionMetrics Source: Lehman Brothers, OptionMetrics Dispersion Trading The last twelve months provided a few attractive opportunities for entering into index dispersion trades in response to periods of elevated implied correlation relative to realized correlation. The implied- realized correlation spread first peaked in April (Figure 9), as investors demanded a relatively high degree of systematic protection to hedge their portfolios from market retracements, such as the credit- driven downturn in the spring. However, there was an opportunity to profitably unwind the position shortly thereafter, when the equity market rallied into May and market-related anxiety dissipated.Figure 8: 3-Month Implied and Realized Correlation (S&P 500) Figure 9: Correlation Spread (3-Month) Versus Index Level 45 20 1300 Possible Entry Points 40 15 1250 S&P 500 Index Level 35 10 Correlation Spread 1200 Correlation 30 5 1150 25 0 1100 20 -5 Possible Implied Correlation (3m) Implied Realized Correlation Spread Exit Points Realized Correlation (66d) S&P 500 Index (RHS) 15 -10 1050 5 5 5 5 5 5 5 5 05 05 5 5 5 5 5 05 5 5 05 05 5 05 5 5 -0 -0 -0 -0 -0 -0 -0 -0 -0 -0 -0 -0 l-0 -0 -0 l-0 -0 -0 b- b- n- n- n- n- ay ay ar ug ar pr ug ov pr ct ep ov ct ep ec ec Ju Ju Ja Ju Fe Ja Ju Fe O O M M A M A M N N A A D D S SSource: Lehman Brothers Source: Lehman Brothers, Bloomberg There were several other opportunities to enter dispersion trades between August and October, again driven by elevated systematic anxiety resulting from the uncertain interest rate outlook. However, as the market recovered in November, reduced demand for market level protection provided an attractive exit point for dispersion trades, as implied correlation again retreated to levels below what had been realized. Options with Weekly Expirations (“Weeklys”) In October 2005, the CBOE launched index options with weekly expirations on the SPX and the OEX. Weeklys have similar contract specifications as other options on their respective underlying indexes. However, they are listed each Friday and expire the following Friday. No Weeklys are listed on the January 10, 2006 7
  8. 8. Equity Derivatives Strategy | Options Strategy Monthly: Low Volatility in the 7th Inning? Friday before the expiration for standard options. Weekly options on the SPX are European-style with AM settlement, while those on the OEX are American-style, with PM settlement. In our opinion, Weeklys allow investors to more efficiently trade nearer-term volatility than traditional option contracts. Weeklys can provide additional flexibility if one wishes to express directional views on stocks or indices immediately prior to an upcoming catalyst. Figure 10: Average Daily Volumes in Weekly Options SPX Weekly Options Average Daily Volume Volume in Volume in Standard % Volume in Weeklys Options Weeklys November 1,459 344,295 0.42% December 2,301 278,543 0.83% OEX Weekly Options Average Daily Volume Volume in Volume in Standard % Volume in Weeklys Options Weeklys November 2,220 69,404 3.20% December 2,397 52,090 4.60% Source: CBOE While the average volume in Weeklys (Figure 10) currently represents a relatively small proportion of the total volume on standard option contracts (less than 1% market share for S&P 500 index options; less than 5% market share for S&P 100 options), their popularity might increase in the coming year. Option Volumes Continue to Accelerate, Currently Stand at Record Levels In 2005, the use of options as speculative investment vehicles or hedging instruments increased in popularity as the volume of total option contracts traded, as well as open interest, continued to exhibit remarkable growth. In fact, as Figure 11 illustrates, the total number of contracts traded on all U.S. options exchanges (including both calls and puts) increased from 392 million in 2003 to roughly 683 million contracts during 2005, a nearly 75% increase.Figure 11: Total Monthly Volume for Options on S&P 500 Stocks Versus S&P 500 Constituent Share Volume 80 Total Contracts Traded (Mn) Option Trading Volume 70 Aggregate Stock Volume (Bn Shares) has Accelerated Monthly Trading Volume 60 Stock Trading Volume has been Rather Muted 50 Average Monthly Average Year End Contract Volume (MM) Open Interest (MM) 40 30 2003 33 59 2004 44 84 20 2005 57 101 10 0 03 04 05 3 4 5 3 4 5 -0 -0 -0 -0 -0 -0 n- n- n- ay ay ay p p p Ja Ja Ja Se Se Se M M MSource: Lehman Brothers, OptionMetrics In addition, the total open interest of option contracts at the end of the year increased from roughly 59 million contracts in 2003 to about 101 million at 2005 end, a nearly 72% increase. On the other hand, total trading volume in shares of S&P 500 constituents generally remained flat over the same period. January 10, 2006 8

×