A Shift in FocusBy Scott "The-Strategist" Fullman
October 3, 2001
Following the coordinated terrorist attacks on the United States on September 11, analysts reduced their expectations for a rebound in the economy. Already weakened consumer activity was evident by the readings in consumer confidence. The impact of terrorism on the economies of the world has increased the probability of a global recession. Tourism was the first industry to notice the impact, as expected. Consumer spending, especially travel, have many links to other industries and activities, which will surely be affected.
Bond prices rose as the Fed eased monetary policy. The inter-meeting decision to cut the Federal Funds Rate and the Federal Discount Rate by 50-basis points was aimed toward providing liquidity into the markets as a stabilizing factor. We have also been told that the Fed has made plenty of cash available to offset any potential clearing problems following recent events. Another 50-basis point rate cut was announced yesterday, pushing the Federal Funds Target Rate to 2.5%, the lowest level in 30 years.
Stock prices rose at the end of last week as bargain hunters bought depressed shares and mutual fund managers made end-of-quarter adjustments to their holdings. This followed a severe downturn for the major market benchmarks. As a result, the Dow Jones Industrial Average (DJIA) ended the month with a loss of 11.2%, while the broader S&P 500 Index (SPX) dropped 7.3% and the NASDAQ Composite Index (COMPQ) fell by 17.3%. Equity prices were already weak prior to the September 11 events.
VOLATILITIES ROSE SHARPLY
During the summer time drop in share prices, implied volatility levels tended to remain relatively low. We indicated this on several occasions, noting that investors remained complacent and that short-term traders were speculating on a rally. Regardless how low the benchmarks moved, implied volatility levels would register little gains. Finally we began to see these levels rise, just prior to September 11. There was little time to act on this rise prior to that date.
After being closed for four business days, the longest closure period since 1933, the stock and options markets reopened, with equities falling quickly. Adding to the weakness was the 10-day Jewish holiday period, which has been a weak time for stocks on a historic basis. Implied volatility levels rose to their highest levels in three years, as noted by the premium levels for SPX, as illustrated below. This was the precursor to the bargain hunting and quarterly adjustments on Thursday and Friday last week.
Buying pressure that emerged helped to reduce implied volatility levels from their highs rather quickly, but these levels remain above their prior lows.
PUT/CALL RATIOS DO NOT CONFIRM
While option premiums and implied volatility levels rose sharply, there has not been much of a change in the put/call ratios that we follow. While we have seen some bullish readings in the CBOE totals, readings for the S&P 100 Index (OEX), SPX, NASDAQ 100 Index (NDX) and Mini-NASDAQ 100 Index (MNX) have all remained low. This indicates that short-term traders and speculators have been anticipating a rally and have been purchasing calls on that basis. Since short-term speculation is usually incorrect, there is less than stellar probability that the rise in the benchmarks late last week will continue with any meaningful gain. However, share prices remain sharply oversold, and there is the possibility that the would-be call buyers could be correct this time.
WHAT LOWER INTEREST RATES MEAN
As most people who use options are aware, there are several variables that are figured into the time premium value of an options contract. One of the main factors that we usually mention is volatility. One of the others, which is currently having a major impact, is interest rates.
During periods of declining interest rates, the time value for call options usually decreases. This is due to the lower cost-of-carry associated with holding the underlying shares for the writer of the option. Since the holding cost is lower, the writer of the option requires a lower premium to make a profit. Conversely, would-be put writers need additional premium to offset a lower amount of interest earned on the short-sale of stock.
LAST QUARTER BEGINS
As the last quarter of the year commences, many companies are expected to preannounce lower results for the third quarter. In approximately 10 days, actual results for the period will be released, along with forecasts for the end of this year and the beginning of next year. Analysts normally adjust their projections for the following year in October. Additionally, mutual fund managers are likely to dump shares of under-performing issues, since this is the last opportunity to take tax losses for funds.
October holds the reputation for being the month that has imposed the worst punishment on investors. This is partially due to the two factors mentioned in the preceding paragraph. However, there are new factors that are coming into play, which could raise volatility levels.
Many companies are now focusing on 2002 and how to increase their businesses. Additionally, there is expected to be greater focus on the creation and/or use of backup facilities in order to avoid some of the problems associated with terrorist attacks. Corporations will attempt to lure the consumer back with new promotions while cutting expenses.
With volatility levels higher than a month ago, the strategic focus should remain defensive, but toward writing premiums. Conservative investors should consider the use of intermediate-term and long-term covered writes, while moderate investors should look at the utilization of the covered combination. These strategies offer some defensive characteristics. Would-be call purchasers should utilize options that are in-the-money and have a long life expectancy.
Another attractive alternative to using calls is to write out-of-the-money puts with the focus on purchasing the underlying stock if it declines below the exercise price of the contract. The high volatility levels and low interest rates have resulted in higher, more attractive premiums, in most cases.
In order to find the best covered call and put writing strategies, on an options writing basis, we suggest using Ivolatility.com's strategy search functions, found under the strategist label on the home page.
Discipline is an important factor. Regardless of how oversold a stock may look or how appealing the valuation, investors and even traders should implement and adhere to stringent stop points in order to avoid negative trend reversals.