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.