Morningstar Volatility Report for April 16, 2010
An expiration surprise.
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 market prices, as reflected in implied volatility in the options market.
Happy Expiration Friday
This week's sense of market serenity was shattered on Friday when the SEC decided to file a civil lawsuit for fraud against Goldman Sachs Group (GS), possibly as a political maneuver in an attempt to win support on Capitol Hill for restrictive financial services legislation by shining a spotlight one of the dragons believed to have caused the financial crisis. The third Friday of the month is the day that equity options expire for the month, making any big stock price moves on Friday very lucrative or costly for option holders, depending on which side of the trade you stand.
The release of the SEC lawsuit information the night on expiration Friday provided tremendous profits to the owners of bearish option positions on Goldman expiring today and tremendous losses to the market makers holding hard to hedge positions overnight. The expiration Friday announcement also prompted speculation among Internet message boards and conspiracy theorists that Goldman may have used advanced notice of the announcement to place highly lucrative out-of-the-money bearish bets on its own shares as well as the market as a whole.
The Numbers: Broken Routine
The beginning of the week was another page in the logbook of complacency, though it feels like we've forever been reporting on changes in the nuance of the status of rescue packages for Greece. The week's general trend was a continuation of the bull market that ticks up day after day in its seemingly inexorable climb, with the S&P 500 having chalked up yet another percent by the close on Thursday and the VIX having floated near 16%.
The sequence of news behind this placid rise was a bullish premarket on Monday about a Greece standby aid deal and enthusiasm over the kickoff of earnings season by Alcoa , and Monday closed flat with respect to market prices and volatility. Tuesday morning saw a slight dip in the market and spike in uncertainty to only a 16.6% VIX index of one-month volatility on the S&P 500, followed by a decaying VIX and rising market. News of no inflation growth, a lukewarm Federal Reserve Beige Book, a warming of New York economic activity, and a hot and possibly overheating economy in China brings us to Thursday's close, which showed a flat VIX at 16 and a little over a 1% rise in the S&P 500.
Friday's open showed a slight market decline and tick up in volatility on an increase in jobless claims then flattening on a better-than-expected housing-start number when volatility spiked and the market rolled into decline on the SEC/Goldman news. The S&P settled flat for the week, closing at 1,192, but the market was clearly spooked by the action of a government body against a financial-services firm, with the VIX measure of uncertainty closing at 18.41%, up 2.2 percentage points from the week earlier.
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 374 basis points, down 114 basis points for a third week of decline.
The reconvergence between small- and large-stock movements could represent a relaxation about concerns about the quality and stability of earnings and financing prospects of smaller companies. The Russell 2000 index of small-cap companies closed up 1.3% on the week versus a flat S&P 500, having developed its outperformance throughout the week. 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 Versus 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 still looks to next quarter's earnings announcements over this quarter's, but today's news had a marketwide impact on short-term uncertainty, causing the spread between the two to narrow to 1.9 percentage points, with the VXV the larger of the two at 20.3%.
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 rose through the week but eased partially late on Friday to close at 57.7%, up 1.8 percentage points. This increase signals a renewed interest in broad market concerns relative to stock-specific 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
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