SurlyTrader

Long Dated Versus Short Dated Volatility

SurlyTrader — Wed, 08 Sep 2010 23:20:08 +0000

Tracking implied volatility surfaces can be very tricky without the right monitoring program or data collection methodology. The benefit of tracking the surface is that it brings in all dimensions to options trading. One of the anomalies that I have noticed over the last few months has been the persistence of high implied volatility levels on longer-dated options. One easy way of seeing this is by looking at the ATM 1 year option implied volatility level versus the 3 month ATM implied volatility level. Another imperfect way of seeing it is by noticing the steepness of the VIX futures curve.

What I show below is the skew of 3 month and 1 year options on two different dates:

3 Month Vol has fallen rapidly

From the skew charts I would say that selling 3 month vol at 60% moneyness looked great at the end of May. In a difference sense, 1 year volatility looks relatively more attractive ATM and even out of the money under current conditions. Always remember that price action is generally mean reverting, so if you believe in volatility cones you should believe that volatility should be lower over longer periods of times.

Collapsing the Ivory Towers

SurlyTrader — Tue, 07 Sep 2010 17:43:12 +0000

The Economist and other inquisitive media outlets have started to ask the long overdue question: What does paying $250k for a college education from a top tier school really get you…and is it worth it? To set the stage, the economist did a great job of putting the cost of tuition into perspective:

“College fees have for decades risen faster than Americans’ ability to pay them. Median household income has grown by a factor of 6.5 in the past 40 years, but the cost of attending a state college has increased by a factor of 15 for in-state students and 24 for out-of-state students. The cost of attending a private college has increased by a factor of more than 13 (a year in the Ivy League will set you back $38,000, excluding bed and board). Academic inflation makes medical inflation look modest by comparison.”

For most Americans, the cost of their child’s education will be their second largest financial outlay after purchasing a house. For those students who have to pay for their education without help, they can join the ranks of those with an average cumulative debt of $27,800 when graduating from college.

All booms come to an end and I think the ballooning of college costs will find its apex on the supply/demand curve. When unemployment is at 10% it might seem like a gift that only 8% of college graduates under age 25 are unemployed. That gift dissolves when compared to the 3.7% unemployment rate for college grads under 25 in April of 2007. College grads are still better off than the sub-25 year olds without a college education; they are are currently suffering from a 24.5% unemployment rate, up from 11.4% in 2007. The young and unemployed portends for an eerie future similar to Japan’s lost generation of youth.

Just as houses became too expensive for consumers, educations are becoming too expensive for students. While it is arguable true that debt from an education is less destructive than debt from consumption, there is a level where the cost/benefit analysis falls apart. This becomes especially true in an age where education has become democratized for those with enough desire and self-discipline. Want to learn how to program? Why not learn from MIT for free.

Noteworthy News – 09/07/2010

SurlyTrader — Mon, 06 Sep 2010 23:40:05 +0000

Economy:

Economy Avoids Recession Relapse as Data Can’t Get Much Worse – Bloomberg

81% rate U.S. economy as ‘poor’ - CNN Money

Why 100,000 jobs a month won’t lower unemployment rate – CS Monitor

Markets:

Housing Woes Bring a New Cry: Let the Market Fall – NY Times

Analysis: VIX fear gauge leaves Wall Street rudderless – Reuters

Analysis: M&A/credit binge vs double-dip fear – Reuters

Politics:

Obama Unveils Plan to Spend $50 Billion on Infrastructure – CNBC

Bernanke Out of Bullets, But Not Bombs – Business Insider

Banks

JPMorgan Said to End Proprietary Trading to Meet Volcker Rule – Bloomberg

FDIC Q2 Banking Profile: 829 Problem Banks - Calculated Risk

Volatility Reverting to the Mean

SurlyTrader — Thu, 02 Sep 2010 23:43:50 +0000

It is fortunate that I wrote my previous article about stagnant volatility the day before a strong ISM number came out which created a robust equity rally and a precipitous decline in implied volatility. The VIX has decline nearly 15% this week. VIX futures have fallen rapidly across the curve, but if this rally can be sustaining it seems that the futures have a long way to fall:

The front part of the curve fell quickly along with the VIX, but the months further out remain stubbornly high

The gap between the VIX Index and the 2nd month of VIX futures is at 6.86%, which is just off the absolute 6 year high of 7.46% established on August 6th. This gap cannot persist forever:

The gap has to narrow, one way or the other

If the equity markets are able to hold onto their ground, then this looks like a great time to bet on a decline in VIX futures by shorting the October and months further out on the curve (over 32% for Jan 2011?!). If instead we believe that September and October are going to be rotten months, then it would be wise to make a pairs trade through a delta hedged long option straddle in the S&P 500 along with a short position in the VIX futures.

Stagnant Volatility and Investment Choices

SurlyTrader — Wed, 01 Sep 2010 01:35:27 +0000

The fear factor of the markets has existed since the end of April. Greece was at the top of the headlines, May 6th Flash Crash, the crash of the Euro, a double dip US recession, bad S&P 500 earnings, a crash in Chinese real estate, overheating in China, treasury rates showing deflation… I guess I am at the point of saying, “Go ahead and topple already”. I do not really mind seeing crashes in markets, because crashes provide opportunities. What I do mind is a chronic state of fear. Volatility has remained elevated for over 4 months, and we have little more than a 14% correction while retail and institutional investors continue to sell out of equity funds.

The issue at question is whether we have a greater day of reckoning coming. The treasury market would say that we truly do. With a 10 year treasury yield of sub 2.5%, the bond market is prepared for terrible days ahead. Stubbornly, equity markets remain dislocated versus their yield based compatriots. At the same time, I have suggested that it is hard for me to believe that the dividend yields on blue chip S&P 500 companies would be cut, which would make them very cheap compared to their very own bond yields.

What does not help our cause is the election cycle during the fall, a persistently negative employment situation, and the notoriously volatile fall months.

Is 30% really much different than 34%? Three months of Fear.

The chart above only illustrates that the prediction level for volatility has remained elevated. A 34% volatility level suggests a daily standard deviation of 2.14% whereas a 30% volatility level suggests a daily standard deviation of 1.89%. In reality, the 10 day annualized volatility hit a high of 37.86% and the 30 day realized volatility hit a high of 32.53%. That was in the height of the “European Crisis”. Since then, realized volatility has faded while implied volatility has remained elevated.

A very slow decline in Vol

So if you would like to make a bet, I suggest five strategies:

Sell Volatility under the premise that everyone has a heightened sense of fear since the terrible market action of 2008
Go long equities because an 8% earnings yield or 5% dividend yield on the top 100 dividend payers certainly beats 10 year yields on corporate bonds
Buy treasuries because a 2.5% 10 year treasury yield will look phenomenal under our deflationary Japanification
Short equities and buy physical gold because the whole financial/fiat system is unraveling
Hold onto your cash and watch all of the fools chase fool’s gold

To me, 3 seems ridiculous knowing Bernanke’s mindset, 4 makes it seem like I would be better off investing in a bunker with ammo, 5 exposes me to the Bernanke mindset, 2 exposes me to the mentality of 3-5, and 1 seems like a way to take advantage of 2-5.

Austerity Trap

SurlyTrader — Tue, 31 Aug 2010 01:15:45 +0000

The European countries have pointed at austerity as the path to enlightenment. Fiscal discipline and cost cutting will make the markets happy…or will it? If you have looked at the credit default swap level of Ireland lately, you would think that they were just as irresponsible as Greece and currently just as risky as Portugal. In just a month’s time, Ireland’s CDS has been able to match Portgual’s at over 340 bps, which implies about a 25% default probability in the next 5 years.

The reason for Ireland’s gap out in spreads has much to do with credit downgrades. The credit downgrades had much to do with a banking collapse which has an estimated recapitalization cost for the country of $50 billion euros, or 1/3 of the economy. In addition, Ireland ran a deficit of 14.3% of GDP last year which was the largest of the euro-area. On the bright side, Ireland has embraced austerity measures. They have raised taxes where able and have reduced public sector salaries by 13%, yet its cost to borrow continues to climb.

If Ireland is unable to make the Euro experiment work, then I have no clue how Italy, Portugal, Spain, and Greece are supposed to pull their countries together. Ireland was a thriving nation which collapsed under the weight of a financial bubble. Now, they must borrow at costs which rival Portugal’s even though they practice fiscal discipline. It makes you wonder if a credit induced recession can be fought legitimately with fiscal responsibility while others are able to fill the holes with piles of fresh fiat currency.

Noteworthy News – August 30, 2010

SurlyTrader — Mon, 30 Aug 2010 02:00:25 +0000

Economy:

US economic growth is revised down to 1.6% – BBC

This Is Not a Recovery - New York Times (Krugman)

Spreading Hayek, Spurning Keynes - Wall Street Journal

Foot Massage Doubles and Chinese Doubt Official Price Data - Bloomberg

Widespread Fear Freezes Housing Market – New York Times

Chart Book: The Legacy of the Great Recession - Center on Budget and Policy Priorities

Markets:

Is there a government bond bubble? – Economist.com

Stock Market Returns by Presidential Party – Wolfram Blog

Bernanke delivers blow to bond-buying hopes – Reuters

Bargain hunters boost shares – Reuters

Politics:

Bank of England will use ‘all powers’ to stave off any future crisis – Telegraph

Bernanke Says Fed Will Do `All It Can’ to Ensure U.S. Recovery – Bloomberg

Analysis: The uncomfortable mathematics of monetary policy – Reuters

The US Government Matches Every Dollar In Tax Revenue With A Dollar In New Debt – ZeroHedge

The Turtle Wins the Race

SurlyTrader — Sat, 28 Aug 2010 02:22:34 +0000

This Friday’s trading concluded the week with our often schizo “risk-on” mindset. It felt like a relief to have treasury yields rise instead of grind downward to an absolutely dis-inflationary 1%. Second quarter GDP came in higher than the consensus estimate and Ben Bernanke told the world that he would do anything in his power to fight deflationary threats, but at this moment it seems unnecessary to get the monetary weapons out of the arsenal. As far as my themes are concerned, I am certain that regular readers are tired of my pushing of dividend yielding stocks. In a world where only an idiot would buy stocks, I must be out of my mind. I hear a lot of talk about individuals and institutions being incapable of absorbing the inherent volatility of stocks, but they must not have read up on the volatility management strategies that are out there. Volatility? It seems rather incongruous that those very institutions shying away from equities would swallow up a 100 year 5.95% bond from Norfolk Southern. No duration/price volatility to see here…

Dividends have fallen out of favor. That is a fact as investors were more concerned with price appreciation akin to the 1990-2000 run-up. Price movements are exciting! My $50 just went to $100! The truth is less glamorous. As James Montier from GMO points out, the return generator of the S&P 500 over a 1 year time horizon from price movement is nearly 80%, but over a 5 year time horizon dividend yields and dividend growth account for 80% of the return.

Who would have thought that dividends are the key

The truth is that companies that pay dividends actually believe in their earnings. If a company does not pay dividends, then they are usually uncertain about the volatility of their earnings or they believe that it is best to invest their cash in expansion plans or in buying back their own shares. Unfortunately, companies are usually horrible at timing share buybacks and can be terrible with acquisition plans (Time Warner/AOL?). This is not to say that the home runs do not exist, just that they are incredibly hard to find and growth projections are terribly difficult to estimate.

I suggest you read James Montier’s full white paper: \"A Man from a Different Time\" - James Montier

Volatility in Perspective

SurlyTrader — Thu, 26 Aug 2010 22:39:00 +0000

Profunds released a nice infochart that shows volatility in perspective over the last 10 years across different indices. I think this is a nice way to look at data and to make relative value calls regarding implied volatility.

Today’s Option Blogs August 25, 2010

SurlyTrader — Wed, 25 Aug 2010 10:30:26 +0000

Earnings trade management post earnings, an update on OTEX
So, last I reported OTEX was up in the PM after reporting good earnings. As I predicted my short SEP calls lost their extrinsic value but unfortunately gained lots of intrinsic value as the underlying moved up. My plan was take a loss if OTEX moved above its opening high at 9:35am. Well, not all [...]
Short naked put vs. short put vertical spread, open for discussion.
Today, Im going to try a new format. I received an email form a reader that I wrote a relatively quick response to. What I am going to do/try is to post his question here and my response and open the comments up to discussion. Please participate. – Lawrence PS: Ill post a continuation to [...]