Options, Risk Management, Implied Volatility & Co.

[Uncle Max]

A Safer Way to Bank on the Banks

IF DURING THE PAST YEAR any investor with bearish views on the financial sector needed assurance, all they had to do was look at options trading on the Financial Select Sector SPDR (XLF). During the past 12 months, investors traded more than five million XLF contracts at a rate of 5.7 puts for every call, a level of pessimism not often encountered.

Yet the mood toward the financial sector seems to be changing. Yesterday, a portfolio manager bought 40,000 March 37 calls, attracting interest across Wall Street trading desks not only for the size of the position, but also because the trade stood out from the status quo. But looks can be deceiving.

The position, while bullish on the surface, is actually shrewd risk management, and indicative of a nuanced and conservative view of the financial sector. The institutional investor who bought the calls is believed to have sold a number of financial stocks on the assumption that their prices are not likely to rally much further, a trader who requested anonymity said. But to maintain exposure to the financial sector, the manager bought call options on XLF.

Why is this shrewd risk management? The portfolio manager likely sold stocks near annual high prices to lock in gains, and bought options at low prices. The XLF calls are cheap because implied volatility is 7.6%, just hovering above XLF's record-low volatility level of 5.5% set in June 2005.

Implied volatility, a key determinant of options prices, indicates expectations of the extent by which the underlying security is expected to move, up or down. Expectations for XLF are likely so muted and apathetic because the market does not think that there is anything overly negative to worry about that could impact financial stocks.

To be sure, there is a reason why this institutional investor is readying for a continued advance in the financial sector. The Federal Reserve has stopped, at least for now, raising the interest rate, and the game the market is playing now is what will happen to financial stocks should the Fed cut rates. Moreover, investment banking backlogs and mergers-and-acquisitions activity remain robust, which augurs well for XLF, whose 88 component stocks include investment banks and other stocks that will benefit from these trends.

Indeed, XLF has made a strong advance during the past year. XLF, which recently traded at about $35.46, has a 52-week range of $30.24 to $35.76. For the past 12 months, XLF has outperformed the Standard & Poor's 500 index, gaining 19.3% over the past year, compared to 16.22% for the SPY, an exchange-traded fund that tracks the S&P index.

(C) Barron's Nov 1 2006

 

[Muting]

Hi, maxrum
It is an interesting article.
From what I have learnt in my class, this is called market-neutral strategy, that is, selling high priced secuirities while buying low priced securities. It is mostly applied by hedge funds.
By the way, could the VIX (Volatility Index) traded in CBOE be applied in estimating the implied volatility? Or use other methods like historical data to calculate the sigma?

 

[Uncle Max]

From what I have learnt in my class, this is called market-neutral strategy, that is, selling high priced secuirities while buying low priced securities. It is mostly applied by hedge funds.

I think buying low and selling high is a strategy used by anyone who wants to make some money, not only by hedge fund

By the way, could the VIX (Volatility Index) traded in CBOE be applied in estimating the implied volatility?

The volatility of what? VIX based on S&P 500 option prices and includes information from the volatility "skew" by using a wider range of strike prices instead of just at-the-money series.

VIX is based on real-time option prices, which reflect investors' consensus view of future expected stock market volatility. During periods of financial stress, which are often accompanied by steep market declines, option prices - and VIX - tend to rise. The greater the fear, the higher the VIX level. As investor fear subsides, option prices tend to decline, which in turn causes VIX to decline. It is important to note, however, that past performance does not necessarily indicate future results.