Option Implied Volatility for Small Cap Stocks

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Actionable trade ideas for stock market investors and traders seeking alpha by overlaying their portfolios with options, other derivatives, ETFs, and disciplined and applied Game Theory for hedge fund managers and other active fund managers worldwide. Ryan Renicker, CFA


<ul><li> 1. October 10, 2006 Index Volatility Commentary Smallcap Vols Ryan Renicker, CFA 1.212.526.9425 Cheapryan.renicker@lehman.com IWM options have gained in popularity, partly because smallcap beta relative to largecaps is at Devapriya Mallick 1.212.526.5429 multi-year highs. dmallik@lehman.com 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.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 ofinterest that could affect the objectivity of this report.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 1-800-2LEHMAN to request a copy of this research.Investors should consider this report as only a single factor in making their investment decision.PLEASE SEE ANALYST(S) CERTIFICATION AND IMPORTANT DISCLOSURES BEGINNING ON PAGE 8. </li> <li> 2. Equity Derivatives Strategy | Index Volatility Commentary Smallcap Vols Cheap 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&amp;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 700,000 2.0 600,000 Avg SPX Option Volume RTY Beta vs SPX Avg IWM Option Volume 1.5 (Rolling 3-month) 500,000 400,000 1.0 300,000 200,000 0.5 100,000 0.0 0 5 6 7 8 9 0 1 2 3 4 5 6 06 6 06 06 06 06 06 r-9 -9 r-9 r-9 r-9 r-0 r-0 r-0 r-0 -0 r-0 r-0 06 06 l-0 r r p- - n- n- b- - g- r- Ap Ap Ap Ap Ap Ap Ap Ap Ap Ap Ap Ap ay ar Ju Ja Ju Fe Ap Se Au M MSource: 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. Lehmans 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 weeks 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 2 </li> <li> 3. Equity Derivatives Strategy | Index Volatility Commentary Smallcap Vols CheapFigure 3: Spread to Largecap Vols Has Cheapened Considerably Figure 4: Risks skewed to the downside 0.8% % 14 0.6% IWM-SPX Implied Vol (1-Month) 0.4% % 12 0.2% 0.0% % 10 -0.2% Avg RTY vs SPX outperformance 8% -0.4% w hen SPX closes higher Avg RTY vs SPX underperformance -0.6% w hen SPX closes low er 6% -0.8% 06 6 06 06 06 06...</li></ul>


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