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First, a brief market review followed by some thoughts on the relationship between interest rates and option pricing from The Blue Collar Investor.
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iShares Russell 2000 (IWM) 116.58 the lackluster underperformance of small capitalization stocks continues although it retested the breakout above 115. On Friday, it open at 118.08 near the high for the day, but was unable to hold the gain and closed just above the low of the day and within the preciously identified a trading range between 105 and resistance at 117. Should it close above the July1 high of 120.97 it would generate a lot of enthusiasm for equities going into year-end. Powershares QQQ (QQQ) 103.87 last week it underperformed SPX advancing just .63% as technology was one of the weaker groups. Following the same pattern of IWM, Friday it opened higher on monetary news from Europe and China but closed near the low. In the meanwhile, it should attempt to retest the breakout back toward the September 19 high at 100.56 and the gap that may prove to be a breakaway not filled. CBOE Volatility Index® (VIX) 12.90 down .41 for the week after trading as high as 15.24 Thursday and then closing on the low for the day at 13.58 continuing even lower Friday on the advancing S&P 500 Index. The table below shows the VIX cash compared to the next two futures contracts as well as our calculation of Larry McMillan’s day-weighted average between the first and second months
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The November futures expired last Wednesday making the front month December. The day weighting applies 85% to December and 15% to January for a 17.03% premium shown above. Our alternative volume-weighted average between December and January, regularly found in the Options Data Analysis section on our homepage, is slightly higher at 18.96%. Previously we suggested premiums for a normal term structure were 10% to 20%, but a more recent examination of data seems to suggest that premiums above 15% are unsustainable suggesting a lack of enthusiasm for VIX hedging. Premiums less than 10% suggest caution and negative premiums indicate an oversold condition. Last week, the premium started at 6.38% and ended Friday in the newly defined overbought red zone at 18.96%. VIX Options With a current 30-day Historical Volatility of 119.68 and 109.52 using Parkinson’s range method, the table below shows the Implied Volatility (IV) of the at-the-money VIX calls and puts using the futures prices based upon Friday’s closing option mid prices along with their respective month’s futures prices, since the options are priced from the tradable futures.
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Compared to the range historical volatility of 109.52 both the December and January options are inexpensive. From our complimentary Basic Options service, here is the VIX volatility chart for the last year.
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Although the Implied Volatility Index Mean in the chart above is 52.09, the calls are 49.48 and the puts are 54.71. However, the most sensitive at-the-money December 15 call and the one most suitable to hedge a potential oversold condition is 71.05 shown in the data table above and still relatively inexpensive compared to the recent movement of the VIX.
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CBOE S&P 500 Skew Index (SKEW) 138.46 measures the purchase of out-of-the-money S&P 500 Index puts that require a very large downside move to profit from long put positions. An increase of this index indicates greater expectations for an extreme down move. The CBOE explains further, a Skew value of 100 means the perceived distribution of S&P 500 log-returns is normal so the probability of outlier returns is negligible. As Skew rises above 100, the left tail of the distribution acquires more weight increasing the probability of outlier returns. Although there may have been a data problem on October 15 at the correction bottom when it dropped down to 111.31, nevertheless it established a new range with the September 19 high of 146.08. Friday’s close of 138.46 puts it in the upper quartile red zone suggesting more out-of-the money put buying by those anticipating an overbought pull back. Market Breadth Based upon the McClellan oscillator market breadth has improved over the last month confirming the advance. McClellan Financial Publications reports the updated summation index Friday was 2565.40, up another 156.88 points last week after advancing 526.85 points for the week ending November 14. US Dollar Index (DX) 88.31 the relentless advance continues in this all important macro variable as it closed just below the high of 88.39. The next target for the advancing dollar index is the June 7, 2010 high at 88.71where it may stall as the euro has a seasonal tendency to strengthen at year-end. If so this could take some pressure off crude oil prices that also have a seasonal tendency to improve in November and December before reaching a January low. However, expect increased speculation about production cutbacks to intensify before Thursday’s OPEC meeting when US markets are closed for Thanksgiving. CBOE Interest Rate 10 Year T Note (TNX) 2.31. Since China lowered its benchmark interest rates for the first time in more than two years and the European Central Bank implied additional monetary easing by purchasing more debt the chances for rate increases anytime soon are diminishing. |
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With that thought in mind, our friends at The Blue Collar Investor sent us this timely recent article on how interest rates affect option prices. Interest rates and the option Greeks play an important role in understanding option prices. Rho, not considered a major Greek, measures the change in an option’s price resulting from a 1% change in interest rates. When interest rates change, it is normally by 25 basis points, not a full percentage point and that’s why option prices usually don’t change materially. However, as Blue Collar Investors, we need to be educated in all aspects of our investment strategies and interest rates do play a role so starting with a basic premise: When the interest rate rises by 1%, call values will increase by the amount of its rho and put values will decrease by the amount of its rho. Here is an example from an options calculator (www.cboe.com) showing a positive rho for calls and a negative rho for puts as interest rates increase.
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Rho for calls and puts For the 21-day period until expiration, the interest rate is 0.1535 (left side), the cost to own the shares (if the money to purchase the shares is borrowed or the interest lost if not borrowed). Should interest rates increase by 1%, the call value will increase by 1.38 cents and the put value will decline by 1.35 cents from the current value of $1.70 (right side). Given that interest rates generally change by 25 basis points when there is an adjustment, the practical impact on our option premiums would be about one fourth of these amounts. This helps explain rho’s status as a minor Greek. Why rising interest rates increase call value There is an interest advantage buying call options. Assume for a moment that we are interested in a $60 stock and want to purchase 300 shares. The cost before commissions is $18,000. Now if a $30 call can be purchased at parity (intrinsic value only or $30, the amount the strike is in-the-money), the cost would be cut in half to $9,000. The risk and potential reward is one half. The $9,000 not spent buying the shares can be deposited into an interest-bearing account to generate income. Therefore, call options are more valuable as interest rates rise and rho measures the change. Why rising interest rates decrease put value There is an interest disadvantage to buying puts. There is a theoretical cost buying puts, the interest cost to buy the options. When share prices decline puts increase in value in much like professional traders benefit from shorting stocks. When a stock is shorted, cash is generated in a brokerage account resulting in an interest credit (professional traders do pay some interest for borrowing shares that were shorted). The choice then becomes do these traders pay interest as puts are purchased or do they receive interest as shares are shorted? As interest rates increase, put buying becomes less attractive and stock shorting becomes more attractive to professional traders. Rho is a minor Greek, used to measure option premiums as interest rates change. Increasing interest rates make call more valuable while reducing put values. Understanding how and why interest rate changes affect option premiums make us better investors. To learn more about mastering the skill covered call writing and option selling click above.
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In next week’s issue, we will again run our ranker and scanner tools in search of more trading ideas. |
Finding Previous Issues and Our Reader Response Request |
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All previous issues of the Digest can be found by using the small calendar at the top right of the first page of any Digest Issue. Click on any underlined date to see the selected issue. Another way to find them is the Table of Contents link in the blog section of our website.
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As the major large capitalization equity indexes make multiple new highs, it should be no surprise as a coincidental indicator VIX is once again challenging the lower end of its range. Indeed if the S&P 500 Index continues trending higher the VIX could return to the lows seen last July 3 at 10.28. This week we expand the VIX analysis to focus on any predictive value that may also be included in the options data.
S&P 500 Index (
