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Volatility Update: Sizing Up the Small Caps

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April 14, 2016

The market action during the first week of April seemed to reflect a growing sense of investor uncertainty on the macroeconomic front. In the equities market, for example, the S&P 500 was up one day, down the next, back up again, down again, and up again. Energy prices, currency markets, and bonds saw a lot of back and forth as well and these ebbs and flows seem closely tied to unfolding economic trends. Now, however, focus on Wall Street is likely to shift to earnings, and one group worth watching as the numbers unfold is the small caps. Here’s why.

April Showers

Some pre-earnings jitters were possibly to blame for the lack of movement in the S&P 500 last week. Although the first quarter reporting period has already begun, the floodgates on results don’t really open until next week. According to Zacks Investment Research, analysts expect S&P 500 companies to show a dismal earnings growth of negative 10.3% for the period, on 2% less revenues.

Adding to the earnings angst, perhaps, was the ongoing uncertainty on the macroeconomic front. The worries range from the surging Japanese yen, to murky messages on the monetary policy front, to ongoing weakness in the European economy. All of these factors seemed to contribute to the rise in the CBOE Volatility Index (VIX), which was probing 2016 lows near 13 on April 1, but had reached almost 17 less than a week later.

CBOE Volatility Index (VIX)


After sleepy action in the second half of March, the volatility index perks up during the first week of April. Data source: CBOE. Chart source: the TD Ameritrade thinkorswim® platformFor illustrative purposes only. Past performance does not guarantee future results.

Think Small

While VIX moved off its 2016 lows in the first week of April, it was hardly elevated near 15 late last week. Recall that the volatility index tracks the expected or implied volatility priced into a strip of short-term options on the S&P 500 Index, and it hit 2016 highs north of 28 in early February. As noted last week, one reason for the decline in VIX is probably tied to the decline in actual market volatility. The 20-day historical volatility of the S&P 500, which is based on closing prices for the index over the past 20 trading sessions, fell to less than 9% by April 1 from 24% two months earlier.

But just like VIX, historical volatility picked up a bit last week as well. As we can see from the table below, the 20-day HV of the S&P 500 was approaching 11%. That, in turn, is well below the implied volatility of 15%, as measured by VIX. Indeed, it is not unusual for implied volatility to be above actual volatility at any point in time. The same is true for the NASDAQ 100 Index and the Dow Jones Industrials, as VXN and VXD are substantially higher than historical volatility.

IV Index Implied Volatility Historical Volatility
S&P 500 Volatility VIX 15.0% 10.9%
NASDAQ 100 VXN 18.1% 13.4%
Dow Volatility VXD 15.2% 8.9%
Russell Small-Cap Volatility RVX 19.3% 19.3%

Yet, the small caps are telling a different tale. While VIX is a measure of the expected volatility priced into a strip of S&P 500 Index options, RVX is the VIX-like index for the Russell 2000 Small Cap Index. Note that actual volatility of the Russell 2000 is equal to RVX at 19.3%. Furthermore, figure 2 shows the 20-day HV and its recent resilience as well.

Small caps volatility


Small cap volatility remains elevated relative to large caps. Data source: CBOE. Chart source: the TD Ameritrade thinkorswim® platformFor illustrative purposes only. Past performance does not guarantee future results.

So the logic goes: small caps are typically more volatile than the large caps because their earnings and share prices tend to react more rapidly to economic trends. These companies are smaller, with less steady cash flows. In this case, not only has the Russell 2000 been quite a bit more volatile (as measured by 20-day HV) than the larger-cap S&P 500 in the past, but the options market seems to be “pricing in” the prospect that the trend might continue going forward.

Zacks expects earnings growth for S&P 500 companies to remain negative through the second quarter before turning positive in the third and fourth quarters. One reason for the big decline in VIX and actual volatility last month is probably related to expectations for an earnings rebound in the second half of 2016.  Time will tell whether Corporate America can live up to those expectations … and the relative performance of the small caps could serve as an important indicator regarding whether or not it is.

RED Option Strategy of the Week: Synthetics

TJ Neil, Sr. Specialist, RED Option

Editor's Note: As of October 3, 2016, RED Option is now TradeWise.

Synthetics are the building blocks of option pricing. The relationships between synthetics and option prices are one of the first things that professional traders learn and commit to memory. The relationship between calls, puts, and stock can be used in different combinations to replicate any of the three. By knowing these relationships, a trader can “synthetically” create positions that mimic the profit and loss characteristics of any of the three (calls, puts, or stock) by combining two in the correct sequence. This can be advantageous when the standard options or stock are either impractical or unavailable to trade.

All synthetic relationships are based on the equation: call = put + stock. This means a long call position can be created synthetically by buying the corresponding put and buying the underlying stock in the same ratio.

To demonstrate the different long synthetic positions, let’s use an example of XYZ Co. and a combination of the May 30 calls and puts. If a trader wanted to buy 1 XYZ synthetic May 30 call, he would buy 1 XYZ May 30 put and 100 shares of stock. To buy a synthetic put, he would buy 1 May 30 call and sell 100 shares of stock. Finally, to buy 100 shares of synthetic stock, he would buy 1 May 30 call and sell 1 May 30 put.

The basic synthetics are:

  • Long synthetic stock = long call + short put
  • Short synthetic stock = short call + long put
  • Long synthetic call = long put + long stock
  • Short synthetic call = short put + short stock
  • Long synthetic put = long call + short stock
  • Short synthetic put = short call + long stock

(For a more advanced look at synthetics, check out this article on butterfly spreads.)

So now that you know how synthetics are constructed, let’s look at ways traders can use the information. There are times when a trader would like to short a stock, but there are no shares available to borrow. A short stock position could be replicated by selling calls and buying puts in the same series. In the XYZ example, this could be accomplished by selling 1 May 30 call and buying 1 May 30 put to create the equivalent to being short 100 shares of XYZ stock.

Synthetics can also be used to neutralize a current position by making one trade, thus saving on potential transaction costs. Let’s say a trader had 1 XYZ May 30 covered call position (short 1 XYZ May 30 call and long 100 shares of XYZ stock). A covered call is a synthetic short put. If he wanted to neutralize this position without closing the covered call, he could buy 1 XYZ May 30 put, which would “flatten” the position with one transaction instead of two. These are just a few examples of how knowing synthetic relationships can add flexibility and versatility to your trading.

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