In last month’s Volatility Advisor blog posting, we discussed the impact of equity correlations on option. Since 2008, many sectors’ correlations to the broader market remained at elevated levels. In early 2013, correlations began to deconstruct as fundamentals and demand for yield drove a wedge into those historical relationships.
This month we will dive into specific implied volatilities determined by the options market in an effort to demonstrate the dispersion that volatility traders witnessed in the first half of the year. The options market is a great place to assess the forward-looking estimation of the overall market as well as expectations of underlying sectors and their correlations to the market. When trying to determine value from an options perspective, one must have a sense of historical correlations across various time periods and the propensity for mean-reversion over time.
At the turn of the year, the Fiscal Cliff ‘resolution’ caused option premiums to decline as fear subsided. When the equity market shot out of the gates in January, any covered call investor was short volatility, which in hindsight was much too cheap. Seen in the table below, the option market implied normalized returns of +/- 5% – 10% for the subsequent quarter in most sectors 1 of the economy, as measured by the SPDR ETFs. For example, the S&P 500 implied a one standard deviation move of 8.08% in Q1, yet returned 10.6%, which indicated a probability of occurrence of 9.48%. More surprisingly, the defensive sectors—Health Care, Consumer Staples and Utilities—produced returns that were over two standard deviations wider than expected. The run-up in Consumer Staples was so dramatic that its probability was less than one percent.
In other words, a quarterly return of 14.52% in Staples would occur once out of 142 quarters or once every 36 years! Clearly, it would have been better to be long stock as opposed to writing calls during that period.
During Q2, the implied volatility landscape began to shift. Not only did nearly all implied volatilities narrow relative to Q1, but actual results were drastically different. All sectors, as indicated by their corresponding ETFs, were closer to their implied volatilities than at the close of the first quarter. No single segment of the market exhibited greater than a one standard deviation move prior to expiration in June.