Morningstar Volatility Report for May 7, 2010
One Very Nervous Market.
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.
A Flock Of Black Swans
If ever there was an event worthy of the Black Swan moniker, the market action this week is that event. The market value of Proctor and Gamble (PG) swung by $60 billion in a matter of minutes, from an open at $62 per share to a low of $39 and back to $61. Shares of Accenture (ACN) opened at $42, traded down to a penny, before recovering to $41. Same story for Boston Beer Co. (SAM). Each of these returns was many, many standard deviations from the mean for each stock, and the flock of these extreme moves happening simultaneously was the ultimate black swan.
To make matters worse, the Nasdaq has decided to cancel the trades that occurred more than 60% from the open price for 296 stocks, which makes you wonder what happens to the option market makers who depend on those deltas to hedge their open option positions. Even more importantly, having a system that systematically renegs on contracts will have a tremendously detrimental effect on liquidity during the next extreme event. If you are sitting and waiting for an extreme event and are willing to put your capital to work when everyone else is under duress, and the benefits of the risk you have taken are taken away, will you wait around or put money to work again? I wouldn't. Aside from the immorality of breaking contracts between willing buyers and sellers, I think the Nasdaq made a big mistake in reversing trades. Reneging on those contracts will haunt the markets in the next crisis.
Occurrences like this week's market events are perfect examples of Black Swans, a concept popularized by author Nassim Nicholas Taleb. The market impact of debt issues in Europe was being priced into the long term volatility indexes as a "known unknown," but the interaction of the larger market moves with computer programs with fancy versions of stop loss orders couldn't be anticipated, making it an "unknown unknown." The extreme magnitude of the impact resulting from the interaction of the European debt fears with the computers are what made the move a "Black Swan."
The Big Numbers
The week began calmly, with a soothing rise in consumer spending confirming a recovering U.S. economy, leading the VIX troughed below 20% on Monday. Warren Buffett's comments about the rationality of Goldman Sachs' (GS) actions led to a rally in the shares that seemed to translate to the markets as a whole. The remainder of the week, however, was dominated by concerns about the success of the rescue package in Greece and a potential financial contagion to the other distressed EU economies.
Solid economic news including a 5% bump in the march home sales rate and a 1% rise in factory orders couldn't prevent a sliding market and rising VIX through Thursday, when all hell broke loose. The market started panic selling on Thursday, which tripped a number of computerized trading thresholds, driving many stock prices near zero and driving the VIX above 40% and the S&P 500 index down by more than 9% before a recovery of much of the loss.
Friday marked a continued sell-off in the market, with an even more concerning continued rise in uncertainty. After a midmorning peak, the VIX continued to rise through the day to close the week at 41.1%, meaning the market is anticipating some hellacious coming weeks.
We think the current and coming conditions should be a feeding frenzy for option sellers. A combination of depressed prices on companies with strengthening fundamentals and high implied volatility should make for some great put writing opportunities. The challenge will be the width of the bid-ask spread, as option market makers seek to be compensated for increased gap risk in share prices, and to profit from desperate hedge buyers.
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 4.7 percentage points, down from 6.14 percentage points the previous week as the current market fears are expected to affect all companies at a similar magnitude, regardless of size.
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 reversed this week, with the option market more concerned about short term uncertainty than long term uncertainty. The VIX shot up to 4.6 percentage points greater than the VXV, meaning that the market is more concerned about market moves in the coming weeks than during the next quarter.
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 old saw about correlations converging to one in times of market panic held yet again, with a spike in the JCJ on Thursday to 108% (although this is clearly a calculation/methodology error since correlations cannot be greater than 100%). The JCJ closed the week much more concerned about a further big correction at 68%, up from 58% last week, as all stocks are expected to move in unison over European debt 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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