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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

iShares MSCI EMU Index EZU
This ETF employs replication to track the MSCI EMU Index, which includes primarily large- and mid-cap companies domiciled in the European Monetary Union. Sector weightings are fairly similar to that of a broad developed international or pan-European fund, which have higher weightings in financials, materials, telecoms, and utilities, and lower weightings in technology, relative to the S&P 500. This fund does not hedge foreign-currency exposure.

Click here for options on the iShares MSCI EMU Index

For investors wishing to bet that replacement demand for autos will drive higher sales for domestic carmakers, our favorite picks are still Ford F and General Motors GM.
Here is what David Whiston, CFA, CPA, CFE, Morningstar's senior analyst in charge of autos, has to say about GM:

"Although the 'Government Motors' stigma is likely to hang over General Motors Company for several years, we think GM's car models are of best quality and design in decades. The company is already a leader in truck models, so a fully competitive lineup combined with a much smaller cost base leads us to think that GM will be printing money as vehicle demand recovers."

Click here for option prices on General Motors

And here is what Whiston has to say about Ford:

"Ford continues to increase its consideration in America, mostly because it did not take government loans and is making better cars. In 2010, Ford picked up nearly 0.9 percentage points of market share. More emphasis on quality is paying off as well. According to Ford, 'projected resale value of 2010 Ford, Lincoln, and Mercury vehicles after 36 months in service increased by an average of $1,310 per vehicle compared to the 2009 model year--the industry's largest increase among full-line manufacturers.' These higher residual values come from the fact that Ford now makes cars people actually want to own instead of vehicles that are purchased only because of heavy incentives. Another key change is building more Ford models on common platforms, which will improve economies of scale. By mid-decade, Ford expects 75% of its global production, or 6 million vehicles, will come from five vehicle architectures. This move will also allow Ford to switch production faster to meet changing demand while also drastically cutting costs via better economies of scale than in recent decades."

Click here for option prices on Ford

Both GM and Ford are 5-star (Consider Buy) stocks.


Erik Kobayashi-Solomon is co-editor of the Morningstar OptionInvestor online newsletter and research service, and co-author of the Morningstar Investor Training course on Option Investing. For more about Morningstar's fundamental approach to investing in options, please use the link below to download our free guide to option investing:
http://option.morningstar.com/OptionReg/OptionFreeDL1.aspx

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