Wall Street firms, including Salomon Smith Barney and Banc of America Securities, are recommending customers sell short-dated single-stock implied volatility to take advantage of the Nasdaq Stock Market's roller coaster ride and the Federal Reserve's surprise 50 basis point interest rate cut last week. Leon Gross, managing director and head of global equity derivatives research at Salomon Smith Barney in New York, suggested selling short-dated calls on new economy stocks, such as Cisco Systems and CMGI, and buying longer-dated calls, after short-dated vol spiked dramatically Wednesday. Salomon is pitching the trade mainly to hedge funds in notional sizes of about USD10 million. In a typical trade a customer might sell three-month Cisco options struck at-the-money with implied vol of 80%, and buy one-year options struck at-the-money with implied vol of 62%. The customer wins if the downward slope on term structures flattens in the near term. By changing the ratio of long options to short options, the investor can instead take a view that implied volatility on the longer-dated position will be higher when the short position expires than the forward vol is now. In this particular example, the ratio of the notional sizes of the options could be 1:2.
Historical vol has been high recently. "We've had a very volatile last month. We've had a very volatile last three months. We've had a very volatile last year," said Gross. Most market makers have been pricing vol at a discount to high historical vol, adjusting the discount linearly downward. This means that the slope on term structures is distorted.
Banc of America Securities is recommending mutual fund clients write covered calls on tech stocks, noted Felix Frey, principal, derivatives sales for hedge funds and mutual funds in New York. It makes sense to sell calls on shares that have not been beaten down too much recently—in particular those with high price/earnings ratios, for example, Broadcom.
Jerry Hanweck, head of equity derivatives strategy at J.P. Morgan in New York, said there are still opportunities in buying vol, particularly in cyclical sectors such as automobiles and financial institutions. With unemployment data being released Friday as DW went to press and retail data to be released this week, and a number of companies set to make earnings announcements this month, vol could continue to shoot up for some companies.
