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Short Selling Ban, Part III: Implications for Implied Volatility

Compromised markets create compromised data.

The impact of the short ban on the equity options market has been profound. There is debate surrounding the S&P level for Friday’s open that was used to calculate settlements given the fact that the final status of outlier prints on financial stocks from that morning is still up in the air. Meanwhile, bid ask spreads in some put series are wide enough to drive a truck through and the normally staid volatility levels for blue chips like GE are in the 40’s or higher.

When we say “volatility” we are talking about one of two things –either realized historical volatility or the volatility implied by option premiums. The VIX Index, the most commonly used barometer of market volatility, is a measure of the implied volatility of options on the S&P 500.

Implied volatility is calculated through a process of reverse engineering. Using a pricing formula such as Black Scholes, the premium for an option is used to derive the implied volatility level by backing out the known aspects (the maturity and strike price) as well as assumptions (the financing rate and hedge). These pricing formulas are all based on the assumption that a trader will be able to freely hedge the option exposure in the underlying market. The shorting ban leaves implied volatility calculations for those stocks heavily compromised by asymmetrical liquidity.

This may sound very abstract and irrelevant at first, but consider what a significant portion of equity trading volume is generated by quantitative managers who rely on implied volatility as an input for their modeling process. By changing the rules mid-game the SEC may be forcing these players to head for the sidelines.

Andrew Barber
Director

Hail Hagupit

Typhoon Hagupit is causing significant disruption in South East Asia, resulting in flight cancellations and ferry service suspensions. Hagupit is currently classified as a Gale Signal 8 (out of 10) which is the equivalent of a category three hurricane. The worst effects of the typhoon may be felt in Macau late afternoon today, Eastern Standard Time (early tomorrow morning Macau time), according to our source in Macau.

While we expect the existing casinos to withstand Hagupit with only limited damages, there is risk to the gaming projects currently under development. LVS has some major projects under construction on lots 5 and 6. Parcel 5 will include three hotels (two Shangri-La Hotels and Traders and one St. Regis), a casino, a retail shopping mall and approximately 320 serviced luxury apartment hotel units. Parcel 6 will be comprised of two hotels (Starwood’s Sheraton brand), a casino and a retail shopping mall. City of Dreams, a project being undertaken by Melco PBL Entertainment, could also see construction disruption. Damages and opening delays are likely.

We will have an update on any damages later today or tomorrow.


These Senatorial Statements Don't Sound Supportive...

I don't want to breakdown each of these politically partisan statements. If you are watching this on TV right now, you'll notice that both the ranking Republican and Democrat are equally negative on Paulson's plan.

Be careful out there. This is going to take time to fix.
KM

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GPS: Gap Doing Something Right???

It’s rare that Gap, Inc gives me an opportunity to pat it on the back for anything, but its deal to buy Athleta for $150mm (about 1.5x sales) makes a ton of sense to me.
  • We’re talking a rounding error to Gap’s P&L and balance sheet – Athleta is only 0.6% of sales – but from a fragmentation standpoint this is the way to go. Aside from certain high-end apparel categories, the athletic space is the only growing category that consistently grows, and the fruits are largely shared by fewer than a dozen brands (Nike, Adidas, UnderArmour, Lulu, Lucy, Champion, Juicy, Reebok, Asics, and Russell). Gap’s core brands, on the flip side, compete with virtually everyone. Not good.
  • This actually gets Gap into a category where it can add some value. In fact, I wouldn’t be surprised if we’re sitting here 3 years out and Gap has grown this into a $300-$400mm brand.
  • Unfortunately for Gap, that’s still a rounding error to its P&L – especially given the margin pressure it has yet to see in its core.
  • Also, I can’t reiterate enough how ridiculous of an idea it is to drive an e-commerce strategy with ALL of Gap’s concepts as part of one customer experience. If I were running Banana Republic, this would take my blood pressure up big time to see customers meshing my assortments with that of Old Navy.
Gap finally getting into a segment of the market that actually grows.
4 (now 5) brands on 1 site... I don't buy it. Crossing over brands marketed to different consumers is a bad deal.

Restaurants/Food – Despite the malaise there are some stock that look good!

Thoughts from Keith's multi-factor model……

Bad break on EAT today, closing below my 18.98 sup line... amazing what any sell side noise is doing to stocks

DIN cracking, looks 15.42 next

PNRA battled it out, and won - looking for an upside test of 60.61

HSY still rides higher on that rumor, looks like $44-45 next; love this name - people hate it

Government Sponsored Volatility

Thankfully, this isn’t Russia or Pakistan, and the US government has not halted trading in our markets yet, so… at 9:30 AM the market will open as usual, but, more importantly, the Senate Banking hearings will also start. I said it yesterday, and I’ll say it again this morning, governments do not put bottoms in markets. What the US government is doing right now changing the rules on the fly and sponsoring volatility and illiquidity as a result.

In the week prior to the short selling ban, we were running huge volume days on the big board (between 6.5-9.5B shares/day) – yesterday volume dropped to 4.5B, and volatility across asset classes shot straight up. Oil had a +24% intraday move! I don’t know why they don’t get this, but hedge funds are critical equalizers out there in finding efficient prices. Some days they can represent 30-40% of the volume in any given market. Now the government is changing the rules on them, banning short selling on down moves and talking about regulating “oil speculating” hedge funds on up moves. Pretty soon we won’t be able to be on any side of the “Trade”!

Confusion breeds contempt in markets, and my thought is that Paulson, Bernanke, and Cox don’t simplify this picture when they are ‘You Tubed’ by politicians this morning. This is an election year. This is too politically charged. This why I am in cash.

Asia closed lower, and European markets are down 1-2% across the board ahead of the 9:30 AM reality TV session with the US government. Yesterday, the S&P 500 failed to climb and close above my critical resistance line of 1258.11, so we find ourselves with the ominous technical combo of both the immediate “Trade” and intermediate “Trend” looking lower. I am going to move my downside S&P 500 target to 1157.22 this morning. I don’t know if we get there today, tomorrow, or on October the 3rd, but that’s my level.

Here are 3 global macro focus levels of downside support to manage risk towards:
1. Hong Kong closed down -3.9% last night at 18,872, and I see immediate downside at 17,427
2. India’s BSE Index closed down -3.1% at 13,561, and I see immediate downside at 12,954
3. London’s FTSE is trading down over -2% so far this morning at 5,112, and I see immediate downside at 4,826

The US Dollar got hammered yesterday, putting in its biggest single day drop since October, 1998. This is not American Idol folks – the world has voted on the Paulson Plan. This US$ weakness, of course, contributed to the melt up in commodities which were amplified by the aforementioned move in oil, but the CRB Commodities Index (19 components) was +3.9% on its own. Bailouts are inflationary.

The “bottom is in” crowd was all over the tape on Friday. Remember, governments don’t put in bottoms. This government is sponsoring volatility and illiquidity – that combo is not going to solve anything any time soon. This is structural. This will take time.

I wish I could see something positive in all of this. I wish I had a more creative solution than being in cash. My critics will tell you that is because I am not as smart as they are. I’d have to agree with them on that.

Good luck out there today,
KM



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