BE CAREFUL WHAT YOU WISH FOR, YOU MIGHT GET IT
For anyone who has followed this blog, you know that I've been expecting market volatility to pick up for months and now it has - and then some... furthermore, there's a storm brewing of macro-economic factors that could keep it around for a while.
First, Chinese markets are in the midst of a correction reminiscent of the US tech bubble of 2001... where short-term valuations got way ahead of the long-term potential of an emerging source of growth. In an apparent and ill-advised measure to save face, the Chinese government has assumed an interventionist role and has attempted to calm markets with asset purchases instead of allowing a natural correction to run its course. Estimates for the size of the intervention range between $100 and $500 billion US dollars. When that intervention ultimately ends, more selling is expected and the contagion effects will be felt globally.
Secondly, domestic markets are staring down the first interest rate increase since June of 2006... for perspective, that was more than 2 years before Barack Obama was first elected president. Last Friday's jobs report showed the nation's unemployment rate has ticked down to 5.1% and the economy continues to add new jobs... albeit not very good ones. When Janet Yellen convenes the Federal Open Market Committee meeting next week, arguments against raising the short-term borrowing rate off of the 0% floor will be hard to justify.
One person lobbying for pause is IMF Managing Director, Christine Lagarde. Her arguments against a US interest rate rise are based on prospects that added strength in the US Dollar would hinder global growth and promote price instability.
"THE REAL VOYAGE OF DISCOVERY CONSISTS NOT IN SEEKING NEW LANDSCAPES, BUT IN HAVING NEW EYES."
-Marcel Proust
Regardless of the actions of policy makers, whether as stimulants or depressants, the simple fact is that we are in a new market landscape. This new environment is a volatile one and that presents a host of challenges and opportunities for options traders.
The New Price of Doing Business:
First, let's look at the challenges... namely, the new price of doing business. Trading in high volatility environments means high implied volatilities which means high options prices.
For example, the implied volatility on the October at-the-money put option for USO is 47%... compare that to a projected volatility of just 15%. To get a visual comparison of the difference, let's look at a price dispersion for both of these assumptions...
Projected Volatility USO Price Dispersion:
Implied Volatility USO Price Dispersion:
Now in all fairness, the projected period return is -6.51% so a vol of 15% is probably a little lite but the difference is still visually dramatic.
In fairness, we should look other names that haven't been as badly devastated as oil so here are a few more examples of the dichotomies between projected and implied volatilities:
Carpe Correctio - Seize the Correction
Just as with any systemic price correction, opportunity abounds to seize undervalued assets. A few names that have been showing up in my factor model as opportunistic longs are GOOG, AMZN, LMT and P.
This current environment also presents a good time to start initiating short volatility positions. I'll go into more depth on this topic later.
For anyone who has followed this blog, you know that I've been expecting market volatility to pick up for months and now it has - and then some... furthermore, there's a storm brewing of macro-economic factors that could keep it around for a while.
First, Chinese markets are in the midst of a correction reminiscent of the US tech bubble of 2001... where short-term valuations got way ahead of the long-term potential of an emerging source of growth. In an apparent and ill-advised measure to save face, the Chinese government has assumed an interventionist role and has attempted to calm markets with asset purchases instead of allowing a natural correction to run its course. Estimates for the size of the intervention range between $100 and $500 billion US dollars. When that intervention ultimately ends, more selling is expected and the contagion effects will be felt globally.
Secondly, domestic markets are staring down the first interest rate increase since June of 2006... for perspective, that was more than 2 years before Barack Obama was first elected president. Last Friday's jobs report showed the nation's unemployment rate has ticked down to 5.1% and the economy continues to add new jobs... albeit not very good ones. When Janet Yellen convenes the Federal Open Market Committee meeting next week, arguments against raising the short-term borrowing rate off of the 0% floor will be hard to justify.
One person lobbying for pause is IMF Managing Director, Christine Lagarde. Her arguments against a US interest rate rise are based on prospects that added strength in the US Dollar would hinder global growth and promote price instability.
"THE REAL VOYAGE OF DISCOVERY CONSISTS NOT IN SEEKING NEW LANDSCAPES, BUT IN HAVING NEW EYES."
-Marcel Proust
Regardless of the actions of policy makers, whether as stimulants or depressants, the simple fact is that we are in a new market landscape. This new environment is a volatile one and that presents a host of challenges and opportunities for options traders.
The New Price of Doing Business:
First, let's look at the challenges... namely, the new price of doing business. Trading in high volatility environments means high implied volatilities which means high options prices.
For example, the implied volatility on the October at-the-money put option for USO is 47%... compare that to a projected volatility of just 15%. To get a visual comparison of the difference, let's look at a price dispersion for both of these assumptions...
Projected Volatility USO Price Dispersion:
Implied Volatility USO Price Dispersion:
Now in all fairness, the projected period return is -6.51% so a vol of 15% is probably a little lite but the difference is still visually dramatic.
In fairness, we should look other names that haven't been as badly devastated as oil so here are a few more examples of the dichotomies between projected and implied volatilities:
- SPY October at-the-money put: Implied Vol 25.1%, Projected Vol 6.39%
- FXI (China ETF) October at-the-money put: Implied Vol 46.2%, Projected Vol 16%
- GOOG October at-the-money call: Implied Vol 37.2%, Projected Vol 16.4%
Carpe Correctio - Seize the Correction
Just as with any systemic price correction, opportunity abounds to seize undervalued assets. A few names that have been showing up in my factor model as opportunistic longs are GOOG, AMZN, LMT and P.
This current environment also presents a good time to start initiating short volatility positions. I'll go into more depth on this topic later.
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