Today’s themes –U.S. Dollar, Japanese Yen, Australian Dollar, December Eurodollar options, U.S. equity options movers – Countrywide Financial (CFC)
U.S. dollar
It’s amazing to witness the difference a banking bailout can have on investor confidence in the space of just over a week! The immediate reaction to the $2.00 per share price tag on JP Morgan Chase’s purchase of Bear Stearns was not one of disappointment. Rather it was one of fear. The fear surrounded who else might fail and whether the asset situation was worse than realized at this stage of the crisis. As a direct result, stocks and the dollar swooned while bond prices surged. But subsequently the reverse has happened, as traders wonder whether the economy now has a new backstop in the Federal Reserve.
As we noted last week the immediate elevated level of market volatility has once again cooled off back into its trading range, making the CBOE Vix Futures market a splendid place to make a living. The accompanying rally in the S&P 500 index has seen the market push 8.3% off its bargain basement price when trading began on St. Patrick’s Day. Maybe we’ll look back at this turning point later in the year and thank the luck of the Irish.
With the Bear rescue concluded (except for the minor matter of the purchase price) investors are clearly starting to breathe easier. The fact that existing home sales also rose last month for the first time in six months didn’t harm sentiment any either. The dramatic move over the last week has been seen in the dollar and the interest rate space. The “success” of a rescue has coincidently put the economy back at least towards the right track, if not on it. The Fed’s earlier measures of adding liquidity haven’t failed. The market failed to mirror the Fed’s generosity for fear of making bad loans, thus prolonging the liquidity crunch.
The Bear move by both the Fed and JP Morgan Chase has thus instilled economic confidence, helping to undermine the further need for monetary stimulus – not that with rates already at 3% there is much room below. As such, bond prices and interest rate futures tumbled in price, reflecting a lesser likelihood that the Fed will ease further. Meanwhile, the dollar stopped falling. Sure it rallied, but for now it feels safer to refer to the fact that it isn’t necessarily in freefall.
The dollar did exhibit particular strength against both Canadian and Australian dollars. But again, it would be largely safer to say that these currencies showed significant weakness because of their association with the weakness of commodity prices last week. Yet here’s the oddity in this space: commodity prices fell, reacting in part to a dollar rally. Gold and oil prices fell in part for fear of a slowing global economy. Yet the dollar’s rally is taking its cue from the fact that there may now be light at the end of the tunnel. Does anyone else find this a curious circle to square?
Japanese yen
Because of the excessive price gyrations in currency markets, volatility in the options market has surged. Look at the following chart showing implied volatility in the yen as seen in the Philadelphia World Currency Options contract, the XDN, where implied volatility spiked through 20% recently.
With a weakening domestic economy, recent yen strength can only be uncomfortable politically, as well as for the Bank of Japan. With minimal yield appeal for their currency, it had been a safe haven for short sellers who played the carry trade. But the yen has spent months now gathering momentum against the dollar, and has risen from around 120 to about 95 last week. Note that the chart shows the inverse relationship, indicating a rising yen over recent months.
The Aussie dollar saw implied volatility rise to 17% last week, while the Canadian dollar’s decline was matched by a rise to 14% in its options implied volatility. The British pound, meanwhile, saw options implied volatility reach close to 12% and although that might seem lowly, it is elevated by a factor of about 50% over historical volatility exhibited in the trading pattern of the pound.
The key to options trading lies in an understanding of implied volatility, which largely drives the premium of an option. When the underlying asset starts flying around unpredictably market makers raise the price of both calls and puts. In essence, the straddle price, which is a snapshot of a range in which traders expect a nearby option to trade, rises, thus increasing the predicted range. A straddle is a simultaneous long (or short) position on the same strike call and put at the combined cost (or credit) of both options. By adding and subtracting this premium from the strike price, we can see where traders are predicting the underlying asset to remain within between now and expiration.
For example the XDN April 100 straddle started the trading week at a price of 3.86 points, indicating that traders see a price range between now and April’s expiration of 96.14 to 103.86. An investor who believes the yen will violate that range during this timeframe might buy a straddle and pay the premium on both call and put. A seller of a strangle believes one of two things. First, they might agree that the yen would remain within that range before April’s expiration. Second, they might foresee a reduction in implied volatility, which in turn would lower the cost of premiums on both call and put. In such an event, investors would seek lower premiums for directional calls or puts and so force down the cost of an option. By Tuesday the same straddle price had declined to around a mid-price of 3.40 points as implied volatility eased.
Australian dollar
In the case of the Australian dollar with the underlying XDA contract trading at around 91.28, the price of the April straddle at the 92.0 strike is around 2.89 with implied volatility at around 15%. An investor wishing to trade the pure direction of volatility could do so by entering a volatility order type. In the following screenshots we’re showing a straddle sale at the current market price with implied volatility at around 15%. We’ve also displayed a buy ticket showing the implied limit price of 1.93 where we constrained implied volatility on the Aussie dollar to just 10%. Of course, investors can play with the volatility pricing in both directions with this useful tool and it provides a valuable addition to the toolbox when currency movements start flying around in unknown directions.
If the nature of the move is unknown and if the investor has no idea how long the rise in volatility might go on, then volatility pricing could be usefully employed. In the following chart, you can see the structured price of this straddle. Ahead of the commodity bust last week, the price had a range of 3.00 to 3.60 before surging to 3.80-4.20. The current price indicates a couple of things. Don’t forget that time decay also eats at the straddle price, since options are wasting assets. Both the 92.0 strike call and put could expire worthless if the XDA settled there at April’s expiry. Now that we’ve had a major sell off in commodities and currencies, option traders are more sanguine towards a rerun of the same event and so the straddle price is further eroding.
The recent commodity price tumble might have been long overdue in some investors’ minds. And it doesn’t feel as though there has been some cataclysmic event that has caused the global economy to slow to undermine the rally. Unfortunately, the rise in bond yields and general easing of the desperate need for the sanctity of U.S. government debt was the cue to dump gold and oil futures. The rest is history. Some investors may be of the opinion that the commodity dollars have taken an unfair bashing here, which is unlikely to carry on. As such, we looked at a credit put spread on the Australian dollar to see whether there was any value there.
With the underlying XDA trading at 91.61, an investor could sell the April 90.5 puts and limit losses with the purchase of the 88.5 puts for an initial credit of 0.65 points. As long as the index settles above the upper strike at expiration, the investor pockets the net premium. The trade breaks even at the upper strike minus the premium received, or 89.85, while the maximum loss occurs at the lower strike price where the investor has covered the short position. That loss is confined to the distance between the two strikes, which in this case is 2 points, minus the initial credit received or 1.35 points. From a risk/reward perspective, the investor is playing a 2:1 trade favoring losses, but the reward in this type of bullish trade is a credit rather than an upfront cost. From the perspective of an investor looking to call even a temporary bottom for currencies against the dollar, there are plenty of opportunities such as this one to be found.
Of course, for investors who believe that the U.S. economy is in the teeth of the recession right now and that the medicine has already been administered, leaving the dollar vulnerable to a rally, credit call spreads would be the order of the day. Taking advantage of rising call premiums while currencies strengthen against the dollar would be the alternative way to play this market.
Interest rates – December Eurodollar options
The waxing and waning and economic posturing on precisely what state the economy is in has prompted sizeable moves in Eurodollar interest rate futures. It took the December contract just over two months to put in a one percent or hundred basis point rally. On January 9, the Dec future reached 97.00 or an implied 3% yield as the economic picture worsened. By March 14 the contract traded at an implied 2% yield before racing to 98.18 sending the market’s best prediction for year-end rates to as low as 1.815%. As such, implied volatility on Eurodollar futures options has stayed high at anywhere from 45-60% this year.
Prior to mid-January, the market assigned little likelihood of rates falling to 2%, let alone any lower. As such, the cost of the 98.00 (or 2%) strike call option was less than a 10 basis point premium. When the SocGen affair created such financial instability that the Fed was forced to ease rates, these calls jumped to 30 points. During the recent market euphoria when the Fed eased rates to 2.25%, the price of the calls traded at 51.5 basis points. That’s really going some. Don’t forget that to calculate the breakeven here we need to add the price to the strike. Someone prepared to pay 50 points for these calls expects a further three-quarters of a point reduction from the Fed. Right now, the market expects just one further easing from the Fed that would leave rates at 2%, and there seems little upside for those calls, which have since declined to 24 basis points since the December contract now implies a yield of 2.23%.
Another way to look at this is via the straddle. The 2% puts in December are in the money and priced at 48 points. Together, the straddle costs 72 points. That tells us that currently the market expects the year-end yield on the three month LIBOR to be somewhere in the range of 97.28 and 98.72. In either case, the Fed would be back in monetary tightening mode or aggressive easing mode. It seems to us that there is an opportunity somewhere here with elevated volatility and such a high degree of uncertainty over the direction over the future path of interest rates.
U.S. equity options movers – Countrywide Financial (CFC)
As you probably already know, we pay lots of attention to volatility here. The demand and supply of options at prices is reflected in changing volatility. It was such a jump in implied volatility earlier this week that caused options in former mortgage behemoth, Countrywide Financial to pop up on our screens. There was little of interest happening in the share price, but demand for calls was sending a strong signal.
It seems that following the “bidding war” for Bear Stearns, in a JPM versus the common shareholder event, investors are beginning to wager whether or not the Bank of America proposed takeover might see a revision to its price also. Thoughts of a third party and not necessarily Bank of America were also clearly driving sentiment. It also emerged at the same time that another banking lender might be interested in assisting in a Fed rescue package were also perhaps some of the interest. It does seem odd that the market might have turned from fears over who might melt down next, to rallies on who might step in and create a bidding war for a the next fire sale victim.
What we did see, however, was a spike in implied volatility in Countrywide options of more than 25% to 99.4%, making it a top volatility gainers on our platform. What’s also noteworthy here was the surge in buying out-of-the-money April calls at the $7.50 strike, which were bought on volume of more than 14,000 lots– more than half the level of prior open interest – for about 25 cents apiece. This premium reflects an approximate 1-in-4 chance that Countrywide can breach the $7.50 mark by April’s expiration. We’ll continue to watch for signs of meat on the bones of this story – but as of today’s update, Countrywide shares are down 3.2% at $6.08.
Andrew Wilkinson and Rebecca Engmann Darst
ibanalyst@interactivebrokers.com
Note: The material presented in this commentary is provided for informational purposes only and is based upon information that is considered reliable. However, neither Interactive Brokers LLC nor its affiliates warrant its completeness, accuracy or adequacy and it should not be relied upon as such. Neither IB nor its affiliates are responsible for any errors or omissions or for results obtained from the use of this information. Past performance is not necessarily indicative of future results.
