Option Implied Volatility for Small Cap Stocks

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Index Volatility Commentary – Smallcap Vols Cheap

• IWM options have gained in popularity, partly because smallcap beta relative to largecaps is at multi-year highs.

• Smallcaps have recently shown disproportionate participation in any downside moves in the market.

• The two weeks heading into earnings have tended to be a period of smallcap underperformance; largecap valuations continue to be extremely cheap relative to smallcaps.

• The IWM-SPX implied vol spread has cheapened to levels last seen in early June. We believe fundamental and seasonal factors make this an opportune time to enter this spread.

October 10, 2006

Ryan Renicker, CFA 1.212.526.9425

[email protected]

Devapriya Mallick 1.212.526.5429

[email protected]

Equity Derivatives Strategy | Index Volatility Commentary – Smallcap Vols Cheap

October 10, 2006 2

Smallcap Vols Cheap Relative to Largecap Vols

Since the beginning of the year, IWM options have gained in popularity as a punting vehicle. Average listed volume in IWM contracts more than doubled in the month of May in comparison to the previous month. Though volumes have come off in recent months as the demand for downside protection has receded, monthly IWM option volumes remain higher than in early 2006 (Figure 1).

An environment where macroeconomic data was deemed more important for determining the path of Fed policy made the Russell 2000 a more attractive instrument for placing leveraged bets.

Another explanation for the greater use of IWM options could be the increasing beta of the Russell 2000 relative to the SPX, which is currently at multi year highs (Figure 2). This is largely explained by the extremely serene levels of largecap realized vols (1-month realized volatility for the S&P 500 has been hovering in the 7-8% range).

Figure 1: IWMs are the favored punting vehicle in a sell-off

Figure 2: RTY beta to SPX at multi year highs

0

100,000

200,000

300,000

400,000

500,000

600,000

700,000

Jan-0

6

Feb-06

Mar-06

Apr-06

May-06

Jun-0

6Ju

l-06

Aug-06

Sep-06

Avg SPX Option Volume

Avg IWM Option Volume

0.0

0.5

1.0

1.5

2.0

Apr-95

Apr-96

Apr-97

Apr-98

Apr-99

Apr-00

Apr-01

Apr-02

Apr-03

Apr-04

Apr-05

Apr-06

RTY Beta vs SPX(Rolling 3-month)

Source: Lehman Brothers, OptionMetrics Source: Lehman Brothers, OptionMetrics, FAME

Seasonal effects argue for smallcap underperformance in the short run. The two weeks heading into the start of earnings season have tended to be a period of weakness for the IWM. Out of the 15 such periods since 2003, the IWM has finished lower on 10 occasions. The IWM-SPX implied vol spread for the 1-month maturity has also widened on 9 out of these 15 instances.

Lehman’s Equity Strategists have highlighted that based on median forward P/E multiples, largecap valuations are historically cheap relative to smallcaps. In keeping with this and the heightened macro risks, smallcap vols kept getting bid up relative to largecap vols till the middle of August. The spread has been reversing for the subsequent two months.

Following last week’s outperformance of the Russell 2000, IWM implied vols have cheapened further relative to the SPX. 1-month IWM implied volatility currently trades at an 8 pt premium to SPX options. This is the cheapest the spread has been since early June (Figure 3).


October 10, 2006 3

Figure 3: Spread to Largecap Vols Has Cheapened Considerably

Figure 4: Risks skewed to the downside

4%

6%

8%

10%

12%

14%

Jan-0

5

Apr-05

Jul-0

5

Oct-05

Jan-0

6

Apr-06

Jul-0

6

Oct-06

IWM-SPX ImpliedVol (1-Month)

-0.8%

-0.6%

-0.4%

-0.2%

0.0%

0.2%

0.4%

0.6%

0.8%

Jan-0

6

Feb-06

Mar-06

Apr-06

May-06

Jun-0

6Ju

l-06

Aug-06

Sep-06

Avg RTY vs SPX outperformancew hen SPX closes higherAvg RTY vs SPX underperformancew hen SPX closes low er

Source: Lehman Brothers, Bloomberg Source: Lehman Brothers, Bloomberg

Further examination of relative performance since the end of the smallcap rally reveals that the Russell 2000 has also exhibited disproportionate participation in any market moves to the downside. In September, the Russell 2000 outperformed the SPX by 18 bps on average when the SPX closed higher. In contrast, on days when the SPX closed lower, RTY underperformance relative to SPX averaged about 56 bps.

We believe this is an opportune time to enter the IWM-SPX volatility spread. The spread looks cheaper over a 1-month horizon than it does further out the curve. Fundamental and seasonal factors argue in favor of the IWM realizing more volatility relative to the SPX in the short term, than what is currently implied by the spread.


October 10, 2006 4

Figure 5: Macro Volatility Summary

ETF Rich/Cheap Analysis

-2.0 -1.5 -1.0 -0.5 0.0 0.5 1.0 1.5 2.0

XLU

BKX

BBH

IYR

XLF

XLE

PPH

OIH

IBB

XLY

RTH

XLB

XAU

OSX

XLI

SOX

SMH

Cheap > > > > > > > > > > > > RichImp Rel Spread (Std Devs from Mean) Imp SPX Spread (Std Devs from Mean)

Note: Stock option volume is the total volume across all contracts for constituents of the S&P 500.For each ETF, we calculate the number of standard deviations by which the current 3-month implied-realized volatility spread differs from its 1-year average. We repeat the calculation for the ETF implied vs S&P 500 3-month implied volatility.

3-month Implied and Realized Correlation (S&P 500)

0%

10%

20%

30%

40%

50%

Oct-05

Nov-05

Dec-05

Jan-0

6

Feb-06

Mar-06

Apr-06

May-06

Jun-0

6Ju

l-06

Aug-06

Sep-06

SPX Implied Correlation (3-month)SPX Realized Correlation (3-month)

Source: Lehman Brothers, OptionMetrics, FAME3-month Implied and Realized Correlation (Nasdaq 100)

0%

10%

20%

30%

40%

50%

Oct-05

Nov-05

Dec-05

Jan-0

6

Feb-06

Mar-06

Apr-06

May-06

Jun-0

6Ju

l-06

Aug-06

Sep-06

NDX Implied Correlation (3-month)NDX Realized Correlation (3-month)

Source: Lehman Brothers, OptionMetrics, FAME

Source: Lehman Brothers, OptionMetrics, FAME

Note: Implied and realized correlation highlight the relationship between volatility of index options and the volatility of options on constituents within that index. Implied correlation reconciles implied volatility of index options with constituent implied volatility. Realized correlation is computed from the realized volatilities of the index and its constituents.

Term Structure of Implied Correlation (SPY)

15%

20%

25%

30%

35%

40%

45%

50%

0.0 0.5 1.0 1.5 2.0 2.5

Years to Maturity

SPY Implied Correlation

Source: Lehman Brothers, Bloomberg

Term Structure of Implied Correlation (QQQQ)

15%

20%

25%

30%

35%

40%

45%

50%

0.0 0.5 1.0 1.5 2.0 2.5

Years to Maturity

QQQQ Implied Correlation

Cash and Derivatives Volumes

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

6-Jan

20-Ja

n3-F

eb

17-F

eb3-M

ar

17-M

ar

31-M

ar

14-A

pr

28-A

pr

12-M

ay

26-M

ay9-J

un

23-Ju

n7-J

ul

21-Ju

l

4-Aug

18-A

ug1-S

ep

15-S

ep

29-S

ep

Week Ending

Stoc

k O

ptn

Volu

me

(Mn

Con

trac

ts)

0.0

0.5

1.0

1.5

2.0

NYS

E Eq

uity

Vol

ume

(Bn

Shar

es)

Stock Option Volume (SPX Constituents)Equity Volume (NYSE)

Source: Lehman Brothers, OptionMetrics, Bloomberg


Source: Lehman Brothers, OptionMetrics, Bloomberg, FAME


October 10, 2006 5

Figure 6: S&P 500 Index Volatility Summary

S&P 500 Put-Call Skew

0%

1%

2%

3%

4%

5%

6%

7%

Oct-05

Nov-05

Dec-05

Jan-0

6

Feb-06

Mar-06

Apr-06

May-06

Jun-0

6Ju

l-06

Aug-06

Sep-06

SPX 30-delta Skew (3-month)SPX 30-delta Skew (1-month)

S&P 500 Implied and Realized Volatility

5%

10%

15%

20%

Oct-05

Nov-05

Dec-05

Jan-0

6

Feb-06

Mar-06

Apr-06

May-06

Jun-0

6Ju

l-06

Aug-06

Sep-06

SPX Implied Vol (3-month) SPX Realized Vol (3-month)SPX Implied Vol (1-month) SPX Realized Vol (1-month)

S&P 500 Skew (1-week Changes)

-2.0%

-1.0%

0.0%

1.0%

Oct-06

Nov-06

Dec-06

Mar-07

Jun-0

7

Dec-07

Jun-0

8

Dec-08

SPX 1w Imp Vol Chg (95%) SPX 1w Imp Vol Chg (100%) SPX 1w Imp Vol Chg (105%)

Term Structure of ATM Implied Volatility (S&P 500)

9%

10%

11%

12%

13%

14%

15%

16%

17%

18%

Oct-06

Nov-06

Dec-06

Mar-07

Jun-0

7

Dec-07

Jun-0

8

Dec-08

Last 1-wk Back 1-mo Back

Note: The 30-delta skew is calculated as the difference between the 30-delta put and 30-delta call implied volatililty. Weekly changes of implied volatility at the 95% and 105% strike versus the at-the-money strike provide a measure of richening/cheapening of skew.

Note: The volatility term structure shows implied volatility for ATM strike options for each listed expiration. The term spread history plots the implied vol difference between 12-month and 3-month options and that between 3-month and 1-month options for the last 1 year.

Source: Lehman Brothers

Source: Lehman Brothers, OptionMetrics Source: Lehman Brothers

Source: Lehman Brothers, OptionMetrics

S&P 500 Weekly Returns vs Vol Changes

-4%

-3%

-2%

-1%

0%

1%

2%

3%

4%

Jan-0

6

Feb-06

Mar-06

Mar-06

Apr-06

May-06

Jun-0

6Ju

l-06

Aug-06

Sep-06

SPX Weekly Return SPX Weekly Change in Implied Vol (1m)


Note: 1-month and 3-month implied volatility are interpolated volatilities for rolling maturities. 3-month realized volatility is calculated as the standard deviation of daily log returns over a 66 trading day historical window. 1-month realized volatility uses 22 days. Weekly spot returns in the index are compared with weekly changes in 1-month ATM implied volatility.

History of S&P 500 Term Spread

-3%

-2%

-1%

0%

1%

2%

3%

Oct-05

Nov-05

Dec-05

Jan-0

6

Feb-06

Mar-06

Apr-06

May-06

Jun-0

6Ju

l-06

Aug-06

Sep-06

SPX 12M-3M Term SpreadSPX 3M-1M Term Spread



October 10, 2006 6

Figure 7: Nasdaq 100 Index Volatility Summary

Nasdaq 100 Put-Call Skew

-1%

0%

1%

2%

3%

4%

5%

6%

Oct-05

Nov-05

Dec-05

Jan-0

6

Feb-06

Mar-06

Apr-06

May-06

Jun-0

6Ju

l-06

Aug-06

Sep-06

NDX 30-delta Skew (3-month)NDX 30-delta Skew (1-month)

Nasdaq 100 Implied and Realized Volatility

10%

15%

20%

25%

Oct-05

Nov-05

Dec-05

Jan-0

6

Feb-06

Mar-06

Apr-06

May-06

Jun-0

6Ju

l-06

Aug-06

Sep-06

NDX Implied Vol (3-month) NDX Realized Vol (3-month)NDX Implied Vol (1-month) NDX Realized Vol (1-month)

Nasdaq 100 Skew (1-week Changes)

-3.0%

-2.0%

-1.0%

0.0%

Oct-06

Nov-06

Dec-06

Mar-07

Jun-0

7

Dec-07

NDX 1w Imp Vol Chg (95%) NDX 1w Imp Vol Chg (100%) NDX 1w Imp Vol Chg (105%)

Term Structure of ATM Implied Volatility (Nasdaq 100)

15%

16%

17%

18%

19%

20%

21%

Oct-06

Nov-06

Dec-06

Mar-07

Jun-0

7

Dec-07




Source: Lehman Brothers



Nasdaq 100 Weekly Returns vs Vol Changes

-6%

-4%

-2%

0%

2%

4%

6%

8%

Jan-0

6

Feb-06

Mar-06

Mar-06

Apr-06

May-06

Jun-0

6Ju

l-06

Aug-06

Sep-06

NDX Weekly Return NDX Weekly Change in Implied Vol (1m)



History of Nasdaq 100 Term Spread

-2%

-1%

0%

1%

2%

3%

Oct-05

Nov-05

Dec-05

Jan-0

6

Feb-06

Mar-06

Apr-06

May-06

Jun-0

6Ju

l-06

Aug-06

Sep-06

NDX 12M-3M Term Spread

NDX 3M-1M Term Spread



October 10, 2006 7

Figure 8: Russell 2000 Index Volatility Summary

IWM Put-Call Skew

0%

1%

2%

3%

4%

5%

6%

Oct-05

Nov-05

Dec-05

Jan-0

6

Feb-06

Mar-06

Apr-06

May-06

Jun-0

6Ju

l-06

Aug-06

Sep-06

IWM 30-delta Skew (3-month)IWM 30-delta Skew (1-month)

IWM Implied and Realized Volatility

10%

15%

20%

25%

30%

Oct-05

Nov-05

Dec-05

Jan-0

6

Feb-06

Mar-06

Apr-06

May-06

Jun-0

6Ju

l-06

Aug-06

Sep-06

IWM Implied Vol (3-month) IWM Realized Vol (3-month)IWM Implied Vol (1-month) IWM Realized Vol (1-month)

IWM Skew (1-week Changes)

-4.0%

-3.0%

-2.0%

-1.0%

0.0%

Oct-06

Nov-06

Dec-06

Mar-07

Jun-0

7

Dec-07

Jan-0

8

Jan-0

9

IWM 1w Imp Vol Chg (95%) IWM 1w Imp Vol Chg (100%) IWM 1w Imp Vol Chg (105%)

Term Structure of ATM Implied Volatility (IWM)

15%

16%

17%

18%

19%

20%

21%

22%

23%

24%

Oct-06

Nov-06

Dec-06

Mar-07

Jun-0

7

Dec-07

Jan-0

8

Jan-0

9




Source: Lehman Brothers Source: Lehman Brothers, OptionMetrics, FAME



IWM Weekly Returns vs Vol Changes

-6%

-4%

-2%

0%

2%

4%

6%

8%

Jan-0

6

Feb-06

Mar-06

Mar-06

Apr-06

May-06

Jun-0

6Ju

l-06

Aug-06

Sep-06

IWM Weekly Return IWM Weekly Change in Implied Vol (1m)



History of IWM Term Spread

-6%

-5%

-4%

-3%

-2%

-1%

0%

1%

2%

3%

4%

Oct-05

Nov-05

Dec-05

Jan-0

6

Feb-06

Mar-06

Apr-06

May-06

Jun-0

6Ju

l-06

Aug-06

Sep-06

IWM 12M-3M Term Spread

IWM 3M-1M Term Spread



October 10, 2006 8

Analyst Certification: I, Ryan Renicker, hereby certify (1) that the views expressed in this research email accurately reflect my personal views about any or all of the subject securities or issuers referred to in this email and (2) no part of my compensation was, is or will be directly or indirectly related to the specific recommendations or views expressed in this email. To the extent that any of the conclusions are based on a quantitative model, Lehman Brothers hereby certifies (1) that the views expressed in this research email accurately reflect the firm's quantitative research model (2) no part of the firm's compensation was, is or will be directly or indirectly related to the specific recommendations or views expressed in this research report. Important Disclosures Lehman Brothers does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this email communication.

Customers of Lehman Brothers in the United States can receive independent, third-party research on the company or companies covered in this report, at no cost to them, where such research is available. Customers can access this independent research at www.lehmanlive.com or can call 1-800-2-LEHMAN to request a copy of this research.

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Option Implied Volatility for Small Cap Stocks