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Option Spotlight: ETF Options for Euroskeptics

European hope springs eternal, but the problems there are far from solved.

Erik Kobayashi-Solomon, 10/29/2011

Our sector spotlight highlights sectors whose implied volatilities have risen or fallen. This can point to areas of potentially profitable option investments.
We use Morningstar's proprietary industry-level data to find sectors and industries attractive for option-based investment strategies. The chart at the bottom shows how much the average implied volatility for each sector differs from its trailing three-month average (vertical bars, indexed on left-hand scale), and the change in implied volatility from week to week (dark blue line, indexed on the right-hand scale).

Sector-level uncertainty eased greatly from the previous week and is now below, and in some sectors well below, the previous quarter's average.
Sector-level uncertainty continued to fall across the board. The sector whose average implied volatilities are lowest with respect to the previous quarter is consumer cyclicals. Several of our recommendations this week are in the consumer cyclical automotive maker industry, where we think long-tenor call options represent an outstanding opportunity.

Implied correlations are still high, despite the fall in general market volatility.
We compare the implied volatility of the options on the average small- and large-cap stocks with the options on the index to estimate implied correlations, or expectations that all stocks will rise and fall in unison. During times of panic, this measure spikes, and it approached 100% during the crash in March 2009. Despite the large drops in implied volatility this week, implied correlation remains at elevated levels. This indicates that participants in the option market are still on their guard against systematic risk--the risk that structural weakness and broad market declines will overshadow company-specific ones.

Readers of my series of articles on Morningstar OptionInvestor regarding hedging (Part I, Part II, Part III) will recognize this as an opportunity to start looking for broad-based index and sector ETFs to look for protection. This is because volatilities on indexes are going down even while the option market is expecting a fairly significant systematic risk to individual stocks.

As a change of pace from our usual Volatility Report selections, I will highlight a few options on sector ETFs this week for those of you who want to buy some cheap(ish) protection from systematic risk were Europe to drive off the tracks again.

Once again uncertainty about value stocks remains elevated relative to growth.
The ratio has flatlined this week and the implied volatility of value stocks still remains slightly higher than that of growth stocks. Opportunities might exist for identifying stocks with a value classification but limited downside.

Investors wishing to bet that Europe is in for more difficult times might use the present lowered index volatilities to invest in put options on these ETFs.
Vanguard MSCI Europe ETF VGK
This ETF tracks the MSCI Europe Index, which includes about 460 companies domiciled in developed Europe. The weighted average market cap of this portfolio is $40 billion. The top country holdings are United Kingdom (31% of the portfolio), France (17%), Germany (12%), and Switzerland (12%). Top sector holdings are financial services (23%), consumer goods (15%), materials (14%), and energy (11%). Relative to the S&P 500, VGK has much heavier weightings in financials, materials, and telecoms, and much lower weightings in information technology. This fund does not hedge its foreign-currency exposure.

Click here for options on the Vanguard MSCI Europe ETF

Erik Kobayashi-Solomon is a market strategist and co-editor of the Morningstar OptionInvestor newsletter. Learn more about OptionInvestor.
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