Implied Volatility 101

 

The most misunderstood component of options pricing is implied volatility. Successful options traders understand that implied volatility is the key “ingredient” to making proper trading decisions when buying and selling options and options spreads. Volatility in regards to options is measured two fold. The first and most easily understood is called Historical or Statistical volatility. Statistical volatility simply is the volatility of a financial instrument based on historical returns. Statistical (historical) volatility as the name implies, refers to past actual data.

Implied volatility on the other hand refers to a future expectation of price fluctuation. The higher the implied volatility the more one could expect the stock or underlying instrument to move in either direction. Conversely, the lower implied volatility references a more stagnant underlying instrument. This implied volatility is an extremely important component of options pricing and its effect on an options price is what makes an option either “cheap” or “expensive”.  Rising implied volatility makes options more expensive and conversely decreasing levels of implied volatility makes options less expensive.

Of all the inputs that go into pricing models such as the Black-Scholes options pricing model, implied volatility is the only variable component. The other components of the pricing model are exercise (strike) price, the riskless rate of return, time until expiration, and the price of the underlying. Implied volatility (variable) is determined by the market maker and is based on the public’s expectations of upcoming events that may change the ultimate value of the options contract. Market makers who are charged with making a market for these instruments increase and decrease implied volatility to increase or decrease the price of the option. The other components mentioned above are all factual and are not based on subjective interpretation.

Because of what I just mentioned above, sharp traders realize that money can be made in strategies that exploit the expected moves (or lack of  movement) in implied volatility. There are many strategies that can accomplish this but the general rule of thumb is that if your expectation is for decrease in implied volatility, then being a seller of an options contract would behoove you . Conversely the opposite would apply; being “Long Vega” or buying volatility would benefit the trader who believes implied volatility is set to rise.

3.4% Increase In Durable Orders

 

The market was caught by surprise again today as orders for durable goods rose for the first time in 6 months. The 3.4% increase beat analysts expectations of a 2.5% decline and offers a break from 6 months of deteriorating economic news.

On Monday, the market was surprised by an 5% increase in existing home sales and on Tuesday, the government reported a rise in home prices after 10 consecutive months of declines. This follows earlier reports that consumer prices were thought to be stabilizing and that retails sales also seem to have fallen much less than expected in the month of February.

These recent numbers are not exactly “good” readings on the economy but they do signal that the economy may have begun to feel the impact of the massive deployment of capital in the form of stimulus, bank bailout measures and loosening credit. Although economists agree the recession is still not contained, the better than expected news was received as a catalyst lifting the markets over 20% from the recently set lows.

Despite the apparent break in the onslaught of bad news, most economists agree we are not out of the woods by any means. Manufacturing activity is still in for some rough months of steep declines as job cuts and reduced capital spending work its way through the economy.

This recent bullishness has place the broad market in a precariously dangerous short term oversold condition and we are very likely to see some retracement of the recent rally. If anything this would be a healthy sign for the market and should be followed by broader buying if critical levels are held.

We do not forsee a retest of the recently set lows until the late spring early summer period and we believe this recent low will mark another intermediate bottom for the markets.

Is Suspending Mark To Market A Good Idea?

 

There has been much debate all over the web as to the benefits and pitfalls of Mark to Market accounting rules. Many are of the opinion that MTM is the only way to get an accurate price for any asset. These folks also argue that without MTM you would have much less transparency of institutions balance sheets. Very valid points.

On the other hand there are those who feel MTM rules have been a catalyst to this financial crisis. By allowing banks and other financial institutions to mark so called level 3 assets to whatever they felt was fair market value. This has had the effect of inflating banks balance sheets and distorting earnings thereby inflating stock prices and CEO bonuses…Valid points as well…

Here is my take on this. The issues that have lead us down this path over the past several years are in part a glitch in the accounting model used by banks. Now before anyone goes off on me for believing the crisis is the fault of some accounting rule, hear me out.

MTM rules gave rise to three levels of assets, which we all have heard of by now:

Level 1 assets are assets that are liquid and where market prices are readily available such as the stock of a company like microsoft.

Level 2 assets are assets with limited liquidity but not so thin that a fair market value cannot be obtained by using what the FSAB (federal standards accounting board) calls “observable inputs”.

Level 3 assets are assets that are deemed impossible to value because of absolute lack of liquididty and a market in general.

Prior to November of 2007, banks were able to mark assets to whatever model they felt appropriate and justifiable to regulators as “fair market value”. Here is where the seeds of this crisis were sown. Banks became extremely aggressive in growing their level three assets exposure. Securitization of mortgage backed securities exploded and everything sent to wall street was packaged into a bond and found a market somewhere around the world. Banks used these “marks to fantasy” to inflate balance sheets which thereby inflated equity prices which helped pay these CEO’s the outrageous pay packages we are so familiar with today.

In November of 2007 the FSAB issued the now also famous rule 157 which stated that institutions must use current prices and market conditions to mark level 3 assets. That is a huge change of winds. Banks now where caught off guard with tremendous amounts of these illiquid level 3 assets that now had to be marked to more market relevant levels. This one change in the accounting rules started the bursting of the housing bubble. Now by no means do I believe the housing crisis was caused by MTM. The cause was compounded by MTM. Over leverage, lax regulatory environments and over building all helped create the mess we are in today.

The question one must ask is what can be done to correct this? Well I believe there are some remedies. One is to suspend mark to market rules for a period and allow a more functional market to develop. Another is to allow banks to amortize these losses over several years instead of taking the losses immediately. Another is to restrict how much a bank can keep of these level 3 assets in the books. I believe that an answer may lie in a combination of several of these options. What I do know is that something must be done to address this loophole now.

Where Do We Go From Here?

 

Many traders and investors alike are shell shocked these days as the broad markets make slow methodical moves to the downside. The fact that the recent stunning headlines regarding GDP and the defacto nationalization of Citi etc have not caused outright panic is in itself reason to worry. Many traders will tell you that this slow and orderly downdraft is actually much more dangerous than a “washout” session or series of sessions marked by heavy selling, high volume and spiking volatility. This recent breach of the technical lows set in November actually sets us back in the recovery of the markets because we are again in the phase of establishing another short term bottom. When the support level is finally established, it will be followed by several tests before the market can trend meaningfully higher.

With that being said, it is very conceivable that we will see a very brisk short term bear market rally in the next few trading sessions. Short term, the market is substantially oversold and even though I am of the opinion that we will be heading lower over the next few months, I believe a short term rally is in the cards.

As I mentioned, longer term we are bearish on the markets.The stock market is dealing with several issues that have been compounded by ineffective actions in the handling of this crisis. At the moment, the root causes of this crisis are still unresolved

1    The deteriorating value of residential real estate and mounting foreclosures. 

2    The amount of illiquid “toxic” assets in institutions balance sheets.

3    The unwinding of the estimated 70 trillion dollar credit default swap market (ie AIG)

The resulting effect of the inability of the government to address these issues effectively is a tremendous drop in business and consumer confidence. Confidence in the fact the consumer will be employed next month or confidence needed to take the risk and expand a business or for banks to make more loans. The effect of this lack of confidence is devastating to the economy and the stock markets. Capitalism is based on the risk taking ability of individuals. Without the confidence needed  for consumers and businesses to take risk, capitalism is stiffled and the void has to be filled by government as we see happening at the moment.

The trading opportunities generated by this instability will make many traders very wealthy while those who continue to believe in the fallacy of “buy and hold” will continue to pay dearly for years to come.