Morningstar Volatility Report for March 26, 2010
A round trip through more certainty.
Investing Specialists
Introduction
The Morningstar approach to options is focused on using company and economic fundamentals to interpret and estimate the value of the uncertainty around stock prices, as reflected in implied volatility in the options market.
A Narrow View of The Future
We've often talked about the VIX as a measure of short-term uncertainty, describing the range of outcomes for the S&P 500 that is handicapped by the market. As the VIX has been making new post-crash lows, we've been thinking about how to emphasize the relative panic or complacency implied by the VIX. We think the range of outcomes for the S&P is a much more intuitive measure of uncertainty than an implied volatility. This week, the VIX closed at 17.84% and the S&P closed at 1,165. By doing a bit of math and checking a statistical table, we can see that these two numbers imply that the market thinks there is roughly a one-in-three chance that the S&P will close below 1,105 or above 1,225 one month from today (see below for a summary of these calculations).
Putting the current level of the VIX in context, in the height of the panic in October 2008, the VIX was above 80%, implying that the market thought there was a one-in-three chance of the index closing down or up more than 23% one month hence. In contrast, while in the lull of complacency in 2006/2007 when the VIX was below 10%, the option market was suggesting a two-in-three chance of the market hovering in a range of 2.9% of the index closing price one month hence. Maybe it's the pessimist in me, but I was more comfortable with the chance of a 23%-or-greater move than I was of a less than 2.9% move.
A two-in-three chance of the S&P 500 trading between 1,105 and 1,225 a month from now? Both the upper and lower numbers seem a bit tight to us given the uncertainty in current global and domestic economic conditions, not to mention the results of next quarter's earnings.
How We Got The Numbers
The VIX is an annualized standard deviation estimating the volatility of the S&P 500 during the next month, but that volatility number can also be translated into a range of probable outcomes or, as we like to think about it, as a wedge of a probability distribution. By "deannualizing" the VIX and multiplying it by the index, we can describe a range of outcomes 30 days into the future.
The range of outcomes described by volatility increases as a function of the square root of time. That means that a given volatility that describes a 66% probability range for a security one-time period in the future will describe a range two time periods in the future that is square root of two, which equals 1.41 times as wide. So, the range of outcomes described by the VIX for one month is the square root of 1/12 times as wide as the value of the VIX. In other words, the range of outcomes predicted by the VIX for the S&P 500 is the current value of the S&P 500 plus or minus the value of the S&P 500 multiplied by 28.9% times the value of the VIX.
The Numbers
The S&P 500 again rose by more than 2% by midweek but dropped later in the week to post a net gain of only 1% by the end of the week. The Russell 2000 rose by almost 4% but dropped to just under a 2% gain by the end of the week, partly reversing its weakness relative to the S&P. The trailing-one-month realized volatility of the S&P 500 Index dropped below 8.5%.
The VIX index of one-month volatility on the S&P 500 traded in a range from 16.3% on Tuesday to 18.7% on Friday, almost exactly the same range as last week. The greatest uncertainty for the week came midday Friday as fears over the sinking of a Korean ship near disputed waters combined with the fallout from a weak treasury auction. The low for the week came at the end of the day on Tuesday as the uncertainty regarding health-care reform was removed and the existing home sales number was slightly weaker than expected, calming concerns regarding the timing of federal reserve action.
The VIX closed the week at 17.84%, up 69 basis points for the week, and still well below the long-run average realized volatility of the market of 20%. We continue to think option investors should look for dispersion, or potential moves in specific securities that could be larger or in a different direction than the market as a whole, specifically calls on those companies whose valuations don't fully reflect a return to normalized economic conditions, and puts that more than fully reflect normalized valuations.
Small Stock Uncertainty
The spread between implied volatility on the Russell 2000 Index of small stocks (RVX) and the VIX index of implied volatility on the large-cap S&P 500 closed the week at 5.7 percentage points, up 40 basis points on the week, continuing a trend following a 1.4-percentage-point increase a week earlier.
This rising uncertainty regarding small stocks relative to large could represent funding concerns or a continued concern regarding the quality and stability of earnings.The spread between the uncertainty regarding the short-term share price of small stocks versus that of large stocks had fallen from a high of more than 12 percentage points last April when greater uncertainty about the ability of small stocks to obtain financing during the credit crisis drove small-stock implied volatilities far above the then-high implied volatility for large stocks.
Uncertainty About Next Quarter vs. This Quarter
The spread between the implied volatility of the three-month options on the S&P 500 Index (VXV) relative to the implied volatility of the one-month options represented by the VIX had been inching up for weeks as the market was increasingly looking to next quarter's earnings announcements as the next major expected driver of stock price movement, but this week the spread narrowed by 50 basis points to 2.32 percentage points as current and universal news becomes more of a concern.
Expected Correlation
The S&P 500 implied correlation index (JCJ) measures the expected correlation between the stocks in the S&P 500 until January 2011. The JCJ fell by 1.93 percentage points to 60.93. The decline in expected correlation means that stock specific concerns are becoming more relevant than marketwide concerns.
Philip Guziec is co-editor and portfolio manager of the Morningstar OptionInvestor online newsletter and research service, and is 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
|
