Monday, January 25, 2010

>Equity Derivatives Dynamics (MORGAN STANLEY)

Meaningful drop in volatility: Equity markets have experienced a substantial drop in both short and long-term volatility over the past month, with some retracement in the last few days. The VIX has been in the 17-19% range of late, and we have finally seen sellers of longer-dated volatility emerge as well.

Hedging opportunity: While we expect volatility to continue to drop over time, we think the opportunity to buy near-dated options today is quite attractive, particularly for hedging purposes. Potential headwinds include rising interest rates, a strengthening dollar, and technicals associated with a secular demand for hedging.

Cyclical Sector Hedging

Volatility vs. relative pricing at the sector level: While all major S&P 500 sectors have experienced a drop in volatility, the relative pricing of OTM options show more variability, particularly the cyclical sectors. This variability leads to opportunity.

Hedge Cyclicals now: Downside skew is flattest for Tech, Industrials, and Discretionary. This pattern seems counterintuitive to us, and we advocate buying downside puts for the cyclical sectors as a market hedge. Cyclical hedge pricing is attractive relative to broad market hedges as well.

Attractive hedge payoffs: In scenarios where equity markets fall and cyclicals underperform (which is likely if we were to retrace performance), we see payoffs of slightly OTM put option hedges on cyclical sectors of 3x to 8x.

Upside plays in Tech and Energy: Option pricing post the fall in volatility tells us that upside calls in Tech and Energy are relatively attractive, and we would potentially fund them by selling OTM calls in the Discretionary sector.

To read the full report: EQUITY DERIVATIVES