Eye On Volatility: Time to Sell Vol. On Small Caps?

01/04/09 02:07PM EST
Overall market volatility is declining, but less rapidly for small cap stocks…

This week marked the first decline of 30-day realized volatility on the S&P 500 below 60 since the first week of October and the first time the VIX has closed below 40 since October 1st. As both real and expected volatility on the SPX decline closer to the upper edges of historical averages they remain significantly higher for small cap names. Although the volatility levels implied by options on smaller capitalized stocks are normally higher than that of larger cap names, the current level of divergence remains wider than it has been for years prior to last fall.

From an options standpoint, the traditional liquidity issues facing small cap stocks are exacerbated by the demise of well capitalized “upstairs” trading desks at investment banks and other financial risk intermediaries who used the listed markets as virtual crossing networks for thinner names in years past. Now, with fewer and less well capitalized market makers increasing focused on large cap names expect volume to decline significantly in small cap option land.

The still-rich premiums in small cap names make strategies involving selling options look attractive here, but keep these factors in mind if you are considering any.

1) Need For Patience: Although the premiums for options sellers on small cap names may be attractive, volume is light. It makes no sense to chase the market; pick a price that you deem attractive for the risk involved and stick with it.
2) Fundamental Conviction: In no way, shape or form is this an endorsement of arbitrage or so called “relative value” dispersal strategies – selling options in the current market without a fundamental directional conviction is not advised. For now, tactical equity investing is best kept in the cash market, with any options selling confined to strategic enhancement.
3) Rates: Any long term option will derive a portion of its value from prevailing interest rates since an option seller is providing the buyer with leverage. Any options seller that is using long dated contracts should consider this factor carefully.
4) Duration: the absence of liquidity is a major driver of current high implied volatility. Anyone that is stepping up to sell options in this market to take advantage of this must be prepared to stay to the bitter end. As we said earlier, volume may be lighter by the time options with 6 to 12 month durations expire so don’t count on trading out in advance on that.
As always, feel free to contact me with any questions about any options strategies that you are considering.

Andrew Barber
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