Wall Street’s October was notable for a number of reasons. Obviously, a roughly 9% gain in the S&P 500 (SPX) is nothing to sneeze at. And as stocks rallied, select measures of market volatility—including the CBOE Volatility Index (VIX)—slid sharply. Yet despite the change in the underlying tone from late summer, one thing hasn’t changed: the year-to-date performance of sectors across the equities market remains decidedly mixed. Sector correlations last month fell to levels not seen in more than a year.
While stocks moved broadly higher, VIX, which tracks the implied volatility priced into SPX options, dropped 36% in October. Recall that VIX remained in the 20s for much of September after a turbulent August stirred anxiety levels on Wall Street. Since that time, the market’s so-called “fear gauge” has been in a steady descent and now probes two-month lows (figure 1).
Economically sensitive sectors including basic materials, energy, and technology paced October’s advance. Health care, industrials, and financials were rallying as well. In fact, only the defensive utilities category failed to participate meaningfully in the October advance.
|October||Year to Date|
|*data through 10/29/15
Not All Sectors on Board
The drop in correlations is notable on the daily chart of the S&P 500 Implied Correlation Index (ICJ). It tracks co-movement among individual SPX-listed companies, and tends to trend higher when stocks perform en masse but falls when trading turns mixed. ICJ saw an impressive spike to new highs in late August, but finished October approaching 52-week lows (see figure 2).
Sector diversification is the process of investing a portfolio across different industry groups, say in health care, technology, and financials, for example. Diversification tends to lessen the volatility of an overall portfolio, although there are no guarantees. When correlations reach extremes (as in late August) and stocks fall across the board, sector diversification is much less effective in reducing the overall volatility of a portfolio.
However, the longer-term trend, as we can see from the year-to-date performance of the various market sectors, is a pattern of mixed action. Some sectors perform well, while others lag. The recent drop in correlations could indicate a broad market that’s entering another period of daily change between leaders and laggards. If history is a guide, that scenario will turn out winners and losers among individual sectors and perhaps another period of subdued volatility for the S&P 500 as a whole.
Tom White’s RED Option Strategy of the Week: Broken-Wing Butterfly
Editor's Note: As of October 3, 2016, RED Option is now TradeWise.
We talked a few weeks ago about option butterfly strategies. But did you know there’s a variation on this strategy for more advanced traders, and it plays on imperfection? It’s the broken-wing, or skewed, butterfly strategy.
Recall that a butterfly spread is a neutral strategy that combines a bull spread and a bear spread with a common middle strike price (that’s the butterfly’s body, when charted). It’s a limited-profit, risk-defined option strategy that involves three strikes. The butterfly is constructed using all calls or all puts in the same option expiration series. The ideal outcome is that the underlying stock remains at or near the middle short strike (for long butterflies).
A standard butterfly has long strikes that are equidistant from the short strikes (for example, a two-point differential on each side). A broken-wing butterfly is skewed in one direction. That means the long strikes will be further away on one side (let’s say two points wide on one side, four points wide on the other). See figure 3 for an example. If done for a credit, this configuration transfers risk to the side with the long strike that is further away from the short strike. The broken wing skips a strike or two, which transfers the risk to the further out-of-the-money long strike. For instance, let’s say a stock is trading at $48 and we wanted to buy a broken-wing butterfly to the upside. Instead of buying a 50/52–52/54 call butterfly, we would buy the 50/52–52/56 call broken-wing butterfly.
This strategy is designed to reduce our cost basis, because we typically like to initiate a long broken-wing butterfly for a credit. Since the broken wing butterfly spread transfers the risk from the in the money side to the out of the money side, the call broken wing butterfly spread is used to protect against the stock breaking downwards and the put broken wing butterfly spread is used to protect against the stock breaking upwards. Maximum profit occurs when the underlying expires at the short strike price of the options and maximum loss occurs when the furthest out of the money option expires at or in the money.
Spreads, iron condors, and other multiple-leg option strategies can entail substantial transaction costs, including multiple commissions, which may impact any potential return. These are advanced option strategies and often involve greater risk, and more complex risk, than basic options trades.
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