Interesting Read: Nothing to Fear but Fear Itself
At week's end, that thought is clearly on the minds of traders and portfolio managers as they surveyed battered financial stocks following a conflagration of sub-prime mortgage fears fanned by troubles at two Bear Stearns' hedge funds.
In keeping with the truism that stocks often advance higher on their own merits, but decline on everyone else's, the implied volatilities of options on financial stocks surged higher during the week, reflecting investor fear that other firms, aside from Bear Stearns, were at risk of being bullied by unwieldy subprime positions.
The Select Sector Financial SPDR, which has emerged as the preferred way to quickly gain long or short exposure to the sector, experienced brisk put activity.
Yet, the increases in single-stock implied volatility is proving too alluring, and investors are now betting that the worst is over.
Most investors who use options tend to chose options that expire in three-months and that are slightly out-of-the-money. The strike prices that are ultimately selected reflect an investor's expectations about how the underlying stock price is expected to behave until expiration.
These strategies benefit if implied volatility declines. The risk is that volatility increases, which could happen if sub-prime fears spook the market once more.
However, an analysis of credit spreads and equity options implied volatility as telegraphed by the Standard & Poor's 500 Index suggests the options market is over reacting to sub-prime fears, according to Joseph J. Mezrich, a quantitative analyst with Nomura.
The growth of credit derivatives has linked credit spreads and equity option implied volatility; together they express the market's pricing of corporate risk. When the risk measures in stocks and bonds diverge, Mezrich said the bond market tends to telegraph the proper view – not options. He cited last summer as evidence when equity volatility spiked on higher interest rate fears, and yet credit spreads did not move, indicating the bond market was not concerned. "When equity volatility began reverting back to the risk levels priced in bonds last July, the S&P 500 rose strongly," he said.
Mezrich believes the current market situation is similar to last summer's. "Stock market volatility has jumped, presumably fearful of contagion from sub-prime loan blow-ups. But corporate bond spreads, at least BAA vs. treasuries, do not appear to share this concern," he said.
If past is prologue, the summer may be rather pleasant. After all, the ISE Sentiment Index, or ISEE, which measures call buying, continues to increase, suggesting that there is nothing to fear but fear itself.
Full story: online.barrons.com |
