DJ TECHNICALLY SPEAKING: Volatility Disparity On The Nasdaq
By Steven M. Sears
NEW YORK (Dow Jones)--Every so often volatility, a key part of options pricing, diverges between indexes and equity options.
The derivatives experts at Lehman Brothers Inc. have noticed that options on the top five Nasdaq stocks - Cisco Systems Inc. (CSCO), Dell Computer Corp. (DELL), Intel Corp. (INTC), Microsoft Corp. (MSFT) and MCI Worldcom Inc. (WCOM) - seem inexpensive relative to the Nasdaq 100 index options, or NDX.
The firm recently advised clients of the opportunity for a "dispersion trade," a strategy that exploits the disparity between the price of index options and a basket of equity options.
Indeed, the three-month weighted correlations between the top five Nasdaq stocks and the Nasdaq 100 is now in the mid- to high-70 percentile, compared with an historical average of 70.5%.
"Essentially, you're getting a more volatile asset for the same implied volatility and that's what it's all about. When there's a big disparity under normal circumstances between realized volatility and implied volatility, that's when option prices becomes a great buy or a great sell," said Andrew T. Whittaker, the analyst who prepared the research report.
Whittaker said the dispersion trade began to look attractive two weeks ago, only to disappear, before recently regaining its luster. This trade appears at different times, often when volatility increases throughout the market. Whittaker said its hard to predict when it will re-emerge again.
To potentially benefit from this disparity, the firm said in a research note that investors can initiate a long/short volatility position in equity options and Nasdaq 100 index options. This is important information for anyone who has a position, or is interested in establishing a position, in Nasdaq stocks.
For someone interested in hedging, for example, Whittaker said it would be cheaper to use options on the top five Nasdaq stocks than on the Nasdaq 100 index.
In his report, Whittaker said that implied correlation increases with volatility. "When market returns become especially volatile, correlation typically increases; this was especially evident during late October 1997 (the onset of the Asian financial turbulence)," he wrote. "During this time period, S&P 500 index option implied volatility traded at 30, not much below single stock volatility - and again during the September/October volatility shock in which implied correlation reached nearly 100%."
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