Thursday, December 13, 2007

Implied Volatility as a Sector Drill Down Diagnostic

I have said relatively little about the crisis in the financial sector largely because there are so many others out there who are covering this story in much more detail than I have any desire to get into. Also, my trading is driven largely by technical analysis, charts and market sentiment, with fundamental analysis usually playing a prominent role only in my long-term holdings.

That being said, this blog has an emphasis on volatility and risk, so this morning I pulled up some implied volatility charts in the financial sector and drilled down from general to specific to see to what extent implied volatility might indicate vis-à-vis the possibility of the tide turning in investor fear. I have appended several of these charts below. On the left hand side, they include the generic large cap financial sector index, XLF (components), as well as the securities broker dealer index, XBD, whose volatility I analyzed back in August. On the right side, I have the banks. The BKX (components) is capitization-weighted and thus tilts toward money center banks; the KRX (components) has a strong regional and local focus; and the MFX (components), as the name suggests, includes banks and other financial companies that are heavily involved in the mortgage finance business. For comparison purposes, the BKX is down 18.7% on the year, the KRX is down 20.5% and the MFX is off 44.6%.

From an IV perspective (and yes, many of these companies could use some intravenous fluids) I generally glance at XLF only as a generic overview of the financial sector. The first finding of interest is that implied volatility in the XBD peaked in August and made a double top before Thanksgiving. This is consistent with the widespread belief that Goldman Sachs (GS) has dodged the subprime bullet and other players in this sector have had sufficient time and corporate agility – if not perhaps the ideal risk management policies – to limit any additional damage.

The banks are another story. Implied volatility in the money center banks and regional banks topped out at the end of November and is currently just below the August highs. Still more concerning, if not more surprising, is the performance of the mortgage finance sector, where implied volatility is above the August peak and in the process of challenging the late November high water mark. If I were a meteorologist looking at implied volatility, I would conclude that the storm has passed in the broker-dealer sector, but more thunderclouds are approaching in the regional banking and mortgage finance sectors.

5 comments:

Anonymous said...

Bill, dont know if you saw, but doggy posted that 7500 feb 200 puts were bot today on XBD, for 11.80

Igor

Bill Luby said...

Thanks for the heads up, Igor. I may be on the other side of that trade before too long.

Cheers,

-Bill

F-Trader said...

Excellent, excellent post. Well done, and I'd love to see more of these.

TaiwanTim Heidorn said...

Hi Bill,

This is off the subject a little bit, but I'd like to know if you have commented on the relationship between volatility (mainly VIX) and index trading volume (S&P500). I have noted that back in the autumn of 2000, when the 00 - 02 bear market was just getting started, that volumes decreased relative to the initial, April plunge but VIX remained elevated. We're seeing the same confluence of volume and volatility now. To me, this has bear market written all over it. You have studied this a lot more than I, do you have any personal research or have you read the research of other's in this regard?

Reply here and at VF if you think it is a worthy issue.

TimmyBear, signing off.

Bill Luby said...

Thanks F-Trader,

I'm not sure how reliable comparative sector IV analysis is, but I'm keeping an open mind and will probably do more of this kind of analysis/posting going forward.


Taiwan Tim,

Good to hear from you in this space. Your question is a good one, and I'm sure many have looked into it, but I not aware of any published reports covering the subject you raise, nor have I done any studies of the volume in SPX products and their relationship to the VIX.

A worthy issue? Absolutely. It opens up a who Pandora's box of potential research projects that might have some interesting predictive value. I'll have to put this one in my 2008 research queue -- and I'll holler if I come up with anything interesting.

Cheers,

-Bill

DISCLAIMER: "VIX®" is a trademark of Chicago Board Options Exchange, Incorporated. Chicago Board Options Exchange, Incorporated is not affiliated with this website or this website's owner's or operators. CBOE assumes no responsibility for the accuracy or completeness or any other aspect of any content posted on this website by its operator or any third party. All content on this site is provided for informational and entertainment purposes only and is not intended as advice to buy or sell any securities. Stocks are difficult to trade; options are even harder. When it comes to VIX derivatives, don't fall into the trap of thinking that just because you can ride a horse, you can ride an alligator. Please do your own homework and accept full responsibility for any investment decisions you make. No content on this site can be used for commercial purposes without the prior written permission of the author. Copyright © 2007-2013 Bill Luby. All rights reserved.
 
Web Analytics