Two Option Picks for a Still-Volatile Market

Jason Stipp: I'm Jason Stipp with Morningstar. After a nice, strong run-up from March lows, the market seems to have paused to take a breather as some questions about the nature of the recovery and how sustainable it is have come into the marketplace.

Here with me to talk about some of the levels of uncertainty in the marketplace and some opportunities that that might present for investors is Phil Guziec. He's Morningstar's derivatives strategist and editor of Morningstar OptionInvestor. Thanks for joining me, Phil.

Philip Guziec: Thanks for having me, Jason.

Stipp: So volatility levels have seen a little bit of a wild ride over the last year or so. So tell me, where are we now versus where have we been about a year ago?

Guziec: Well, over the past year, we've seen implied volatility twice what it is now, let's say. Morningstar Volatility Index, which is the average of the implied volatility of all the options in the U.S. option market, had gotten over 100% in March, when the market was undergoing its convulsions. We don't have a long enough history to know the exact historical average or norm for that measure, but now we're looking at something in the 60% range. It had gotten down into the low 50% range just as recently as a few weeks ago.

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Stipp: So we have come up a little bit from a low that we had reached recently. So what do you think is \behind maybe a slightly heightened level of uncertainty over the last few weeks that we've seen?

Guziec: Well, the uncertainty, in aggregate, is driven by economic and earnings factors and all the things that drive the stock market. Particularly, recently we've seen a runup in the implied volatility on financial services companies--banks. Banks had had implied volatilities well over 100%, 150%, in the throes of the crisis, the Lehman bankruptcy, just bankruptcy fears and extreme range of potential outcomes, tremendous uncertainty about the future of banks.

At the low, we had seen 75% as an average financial services volatility. So cut in half, again, basically. And now we're looking in the 90% range. Still very elevated levels of uncertainty in financial services. That's driven, it seems, by fears about commercial real estate, which tends to lag residential real-estate losses at the banks, and what that might do to valuations or to precipitate future failures.

Stipp: So the fear is, potentially, this could be another shoe to drop in financial services. After we've already worked through and stepped away from the abyss, this might still be hanging out there.

Guziec: That's exactly the way I interpret it.

Stipp: OK. And then, within that financial space, if you were an option investor, in that sort of environment that's happening now, how would you start to uncover opportunities based on the volatility and the underlying securities and some mismatches that might be occurring there?

Guziec: Well, any time you have a broad sector with raised or lowered implied volatility, just like high or low valuations, babies get caught up in the bathwater and thrown out.

There's a really classic case, a company called New York Community Bancorp. We actually own it in the OptionInvestor Pay Me Now portfolio, which is primarily selling options in low-risk scenarios. New York Community Bancorp almost exclusively lends on properties that are rent-stabilized. So you have a very high demand, very unlikely that you'll have any kind of material vacancies. So you have very stable cash flows, very limited downside in their loan portfolio.

On top of that, they lend very low loan-to-value, so even if one of these properties were to fall into default and be liquidated, the bank would get a 100% payout. It's extremely conservatively run. They may not have tremendous upside, although it's somewhat undervalued. But the implied volatility is driven up by financials in general and relatively high and, we think, overvalued, so we sold some puts on it.

Stipp: So, basically, selling those puts is like selling \insurance against a highly unlikely event that would happen in the future.

Guziec: Yeah. That's exactly right. We think about it as a probability distribution for the outcomes of the company. And normally, log-normal is kind of how stocks look. They're very high to the upside, but they can only go to zero. But we think New York Community Bancorp has a very low, very curtailed downside tail. So it doesn't really go to zero. It kind of clips off at the current valuation, and the likelihoods of being below that are extremely low.

So, if you're selling insurance on those low-valuation scenarios, that insurance is way overpriced. And that's a good business--selling overpriced insurance.

Stipp: Very interesting idea. Another area where there seems to be some uncertainty is the health-care arena, with all of the potential reforms on the table, but really no clarity yet on how health care is going to play out over the next few years. What have you been seeing in health care, as far as the overall picture and then the potential opportunities on individual names there?

Guziec: It's interesting. Health care's implied volatility is not that dramatically elevated relative to the rest of the market. So I think the situation there is sorting out the undervalued companies, or overvalued companies, in different health-care scenarios.

But probably the best thing is to find companies that it doesn't matter what happens with health care reform, they'll do well, and find the ones that are undervalued. And because the volatility isn't extremely high, you can actually make money buying some options there, possibly, buying some out-of-the-money calls that aren't too expensive.

There's a lot of long-dated calls or LEAPS that trade out to January 2011, and you can kind of think the political process will be worked through by then. So out-of-the-money calls on undervalued health-care companies that do well on every scenario is probably the best option there.

Stipp: So, any specific names that you've been looking at in that kind of a scenario?

Guziec: Yeah, we think Stryker. Also, we've bought that in our OptionInvestor portfolios, in the Pay Me Later portfolio, which is primarily an option-buying or a much more risk-tolerant portfolio. Stryker's trading in the low 40s. We think it's worth in the low 70s. Implied volatility isn't necessarily that high, and you can buy options out of the money for a couple bucks that should be multiple-times returns. And you make small bets that can either give you big returns or, in the worst case, you lose your small investment.

Stipp: Great. Well, thanks so much for the ideas, Phil. It was great talking to you today.

Guziec: Good to talk to you, Jason.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.