UBS Investment Research Option Strategy 2012 Volatility Outlook and Strategies 2012 forecast calls for more of the same: range-bound and highly volatile While U.S. economic fundamentals continue to improve, UBS economists expect slow global growth next year, with a recession in the Euro-zone, elections in the U.S. and other significant sources of uncertainty. Stock earnings growth is decelerating against this backdrop, which makes us expect another year like 2011: range-bound and volatile. We note while 2011 was among the most volatile of the past 20 years, volatility was not uniform through the year, and we expect a similar pattern of high and low volatility in 2012 to provide potential investing opportunities. Pure volatility-based option strategies With 2011 realized volatility above implied and stocks that were mostly range- bound, we believe both tactical long option strategies and strategic short option strategies have the potential to be profitable if 2012 plays out in similar fashion. We explore these strategies and illustrate examples of short option trades on the 2011 market that were ultimately profitable, but with a ride so wild investors were unlikely to see them through. We highlight several 2012 volatility strategies at the Index, sector and stock level. Directionally-based option strategies While we consider option buying, we favor strategies that sell options, as implied volatility remains historically high. Trades include buy-writing and put selling for stocks where our 2012 outlook is positive and call selling/overwriting where it is not. Our outlook is based on a scoring system that weighs the sector, industry and stock preferences of our equity strategists and analysts. Trades are recommended by combining this rank with volatility and price performance considerations. Global Equity Research Americas Derivatives Equity Derivatives 6 December 2011 www.ubs.com/investmentresearch Mitchell S. Revsine Strategist [email protected]+1-212-713 1416 Brian Russo Associate Analyst [email protected]+1-203-719 3692 Contents Topic Section Page Economic and Equity Strategy Outlook 2012 Forecast Calls for More of the Same: Range-bound and Volatile 2 2012 Option Strategies The Merits of Selling Strangles 4 Pure Volatility Strategies (Long vs. Short-dated) 5 Directional Strategies (Index, Sector and Stock) 8 Trade Implementation and Portfolio Hedging 15 Appendix 2012 Stock Outlook Scores 18 This report has been prepared by UBS Securities LLC ANALYST CERTIFICATION AND REQUIRED DISCLOSURES BEGIN ON PAGE 25. UBS does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. ab
Transcript
UBS Investment Research
Option Strategy
2012 Volatility Outlook and Strategies
2012 forecast calls for more of the same: range-bound and highly volatile While U.S. economic fundamentals continue to improve, UBS economists expect slow global growth next year, with a recession in the Euro-zone, elections in the U.S. and other significant sources of uncertainty. Stock earnings growth is deceleratingagainst this backdrop, which makes us expect another year like 2011: range-bound and volatile. We note while 2011 was among the most volatile of the past 20 years,volatility was not uniform through the year, and we expect a similar pattern of highand low volatility in 2012 to provide potential investing opportunities.
Pure volatility-based option strategies With 2011 realized volatility above implied and stocks that were mostly range-bound, we believe both tactical long option strategies and strategic short optionstrategies have the potential to be profitable if 2012 plays out in similar fashion. We explore these strategies and illustrate examples of short option trades on the2011 market that were ultimately profitable, but with a ride so wild investors wereunlikely to see them through. We highlight several 2012 volatility strategies at the Index, sector and stock level.
Directionally-based option strategies While we consider option buying, we favor strategies that sell options, as impliedvolatility remains historically high. Trades include buy-writing and put selling for stocks where our 2012 outlook is positive and call selling/overwriting where it isnot. Our outlook is based on a scoring system that weighs the sector, industry andstock preferences of our equity strategists and analysts. Trades are recommendedby combining this rank with volatility and price performance considerations.
Economic and Equity Strategy Outlook 2012 Forecast Calls for More of the Same: Range-bound and Volatile 2
2012 Option Strategies The Merits of Selling Strangles 4
Pure Volatility Strategies (Long vs. Short-dated) 5
Directional Strategies (Index, Sector and Stock) 8
Trade Implementation and Portfolio Hedging 15
Appendix 2012 Stock Outlook Scores 18
This report has been prepared by UBS Securities LLCANALYST CERTIFICATION AND REQUIRED DISCLOSURES BEGIN ON PAGE 25. UBS does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.
Introduction The purpose of this note is to help option investors, whether pure volatility traders or fundamental investors, consider how to position with options in 2012, given UBS’s macro outlook and volatility perspective. This report covers the following topics: 1) Selling strangles to position for a potential range-bound and volatile market in 2012; 2) The merits of both long and short volatility-based strategies; 3) Portfolio hedging considerations; 4) Consideration of selling some Index and sector strangles; 5) Stock scoring methodology and directional options trades.
2012 Forecast Calls for More of the Same Slow Global/U.S. Economic Growth Expected, with Downside Risks
UBS Chief Economist Larry Hatheway expects the world economy to grow by just 3.1% in 2012 after an estimated 3.2% in 2011, partially due to projections of a Euro-zone recession in early 2012 (but no global recession). UBS Chief U.S. Economist Maury Harris expects the U.S. to be relatively insulated from a Europe recession, but recently lowered his 2012 GDP growth forecast to 2.0% from 2.3% to reflect reductions in export market growth and lowered real business equipment and software spending growth. Though incrementally less positive, Harris points out that U.S. fundamentals continue to improve, specifically the domestic banking system’s ability to channel savings into investment and stabilizing home prices.
Risk to these forecasts seem skewed more to the downside, given financial and sovereign stress emanating from Europe, populist pressures and ineffectual policy-making in both the U.S. and Europe, and geo-political risk that could elevate oil prices.
Expect Equity Markets to be Range-bound and Highly Volatile
UBS Global Equity Strategist Jeffrey Palma expects stocks in 2012 to be plagued by similar issues as 2011, namely decelerating earnings growth, high volatility and poor cyclical visibility. Until this outlook changes, he believes P/E multiple re-ratings and strong asset allocation flows into equities are unlikely. UBS Chief U.S. Equity Strategist Jonathan Golub agrees that equity multiples will remain lower for longer, and anticipates potentially more attractive levels for the market later in 2012 than at current levels. The strategy team targets the S&P500 to reach 1,325 by year-end 2012 (6% above current levels), based on an EPS estimate of $99. This estimate is below the top-down EPS consensus estimate of $104 and bottom-up (analyst) consensus estimate of $108.
Given the UBS forecast for continued high volatility in 2012, we find it instructive to examine historical market volatility (Chart 1) for perspective. Both Charts 1 and 2 indicate that overall, 2011 was among the most highly volatile of the past 20 years, but that extreme volatility was concentrated during the final months of the year. Chart 3 indicates that options are forecasting 2012 market volatility levels to be similar to 2011. We agree with this assessment and expect both low volatility periods and numerous high volatility episodes next year. It should be noted that investors who believe 2012 will be as volatile, on average,
Anticipated Europe recession slows economic activity and impacts U.S. multi-national corporations
Europe risk the focus, but U.S. political failures will also resurface
P/E multiples unlikely to re-rate while earnings growth decelerates and visibility remains poor
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as the August 2011 to present period effectively believe that next year will be similar to the post-Lehman period (Chart 1).
Chart 1: 2011 Volatility In Perspective Chart 2: Past 4 Months Markedly Different Then Rest of 2011
10
15
20
25
30
35
40
1/3/11 3/3/11 5/3/11 7/3/11 9/3/11 11/3/11
3-Month SPX Implied Volatility
Note: ‘91-‘00 is average yearly realized volatility. Source: UBS and Bloomberg Source: UBS and Bloomberg
In addition to high volatility, our strategists also expect markets to be range-bound. UBS Senior U.S. Equity Strategist Thomas Doerflinger makes two important points with respect to this projection:
Europe recession will likely cause a profit slowdown in U.S. companies despite U.S. GDP growth, similar to the Asian financial crisis of 1998 where markets went sideways until a fall rally. An important distinction is that Asia ex. Japan contributed only 12% of S&P500 foreign revenue at the time, while Europe accounts for 44% currently.
2012 is an election year, where much legislation will be postponed until the election is over (for better or worse) and where investors will likely discount the outcome of the November election and its impact on corporate tax reform, regulation, etc. We think this may continue to feed uncertainty among both companies and consumers throughout 2012, and help keep markets from breaking out of a range.
Chart 3: More of the Same: Options Imply 2012 Volatility Similar to 2011
2 reasons why we think stocks could be range-bound in 2012: profit slowdown from Europe recession and investor inaction prior to elections
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What Option Strategies Make Sense in 2012? Given the overwhelming consensus view of our various strategists that 2012 may be range-bound (albeit volatile), investors who employ options as a component of their investment strategy would logically think to capitalize on a range persisting in 2012 by selling strangles (i.e., selling both out of-the-money puts and calls). While this type of strategy might ultimately be profitable at expiration, we point out that the P&L experience of such a strategy over its full life may be rocky.
To illustrate this point, we show the P&L over the life of some S&P500 Index strangle selling strategies that an investor would have actually contemplated initiating, both in December 2010, at both the low and high prices during the month (to express a range view for all of 2011), and at the end of August 2011 (during the height of the European debt crisis uncertainty, when volatility was near recent extremes).
Note from the charts that the P&L was negative for a while, and that it only started to become positive and remain that way later on. Also note in the left chart the short 1,125/1,400 strangle P&L declined to around flat during the re-emergence of the European debt crisis in August. To be fair, many investors do not have the stomach to endure such P&L swings, for a “passive” investment strategy in the current environment.
Given that selling strangles may make sense for some investors and not for others, we broaden our consideration of optimal strategies to pursue in 2012. As such, we consider option strategies to express a view purely on volatility, as well as strategies that employ options to express a directional stock view. While this is a 2012 outlook note, some of the strategies discussed below can be implemented for both an end of 2012 maturity or for shorter periods. Later on we also evaluate the merits of “active” vs. “passive” investment strategies.
It seems logical to consider selling strangles for 2012 to benefit from a range-bound market
P&L swings from strangles sold may be difficult for investors to tolerate
Chart 4: Bumpy Ride, but Year-long Strangles Were Profitable Chart 5: Selling Strangle Post-August Decline Also Profitable
-2%
0%
2%
4%
6%
8%
12/1/10 2/1/11 4/1/11 6/1/11 8/1/11 10/1/11
1,050 Put + 1,325 Call
1,125 Put + 1,400 Call
Profit of SPX Strangles Sold
-1%
0%
1%
2%
3%
4%
8/29/11 9/28/11 10/28/11 11/27/11
Profit of SPX Strangle Sold 1,025 Put + 1,300 Call
Note: A detailed explanation of these graphs is provided on page 17 of the Appendix. Source: UBS and Bloomberg
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Pure Volatility Strategies
With respect to option strategies that primarily express a view on volatility, we consider whether investors should buy or sell options, with a distinction between capitalizing either on gyration in stock prices or changes in the view of future uncertainty. Investors who attempt to capture greater than predicted market gyrations often buy shorter-dated options (say 1-3 months, called “gamma” trading), while investors attempting to capitalize on changing views of future stock uncertainty often trade longer-dated options (6-12 months, called “vega” trading).
Capitalizing on Stock Gyrations
(short-dated / gamma trading)
Interestingly and perhaps not intuitively at first, in a choppy, range-bound market like 2011 (but especially since August), a case can be made that both short-dated long and short option strategies can be profitable. We believe this can be the case both for active long option strategies and for passive short option strategies. We define both terms for clarification below:
Active long option (or long gamma) strategies: These represent volatility traders buying options to express a view that realized volatility will exceed implied volatility. The “active” adjective indicates active position management via frequently re-balancing the option delta through selling the underlying stock on rallies and buying the stock on dips.
Passive short option strategies: These could be implemented by fundamental investors who want to express a view that a stock will remain within a range over a given term. They could sell both an out of-the-money put and call, and not re-balance the position delta over the life of the option, as the stock gyrates within a pre-defined range.
In support of our view, Chart 6 below shows that 2011 realized volatility exceeded implied volatility on average, although more so since August. If the market dynamics in 2012 are similar to 2011, then active option trading could conceivably be profitable.
Chart 6: Long Gamma Was Profitable in 2011… Chart 7: …But Not Uniformly (Mostly Since August)
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1
2
3
4
Jan-July Aug-Present YTD
Amount Volatility Realized Over What Had Been Implied
Av erage S&P500 Stocks
-15-10
-505
1015202530
1/3/11 3/3/11 5/3/11 7/3/11 9/3/11
Amount Volatility Realized Over What Had Been Implied
SPX
Note: Charts are meant to approximate a long option (i.e. long gamma) position. A detailed explanation provided on page 17 of the Appendix. Source: UBS and Bloomberg
A case can be made that both long and short option strategies can be profitable
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Also as seen in Charts 8 & 9, because stocks were range-bound more so than trending in 2011, a case can be made that realized volatility was actually lower for passive investors than for active investors. Hence, passive option strategies could have been profitable in 2011 as well. It follows that if market conditions are similar in 2012 to those in 2011, passive options strategies could potentially be profitable in 2012. To that end, we will discuss the strategy of selling strangles later on.
Chart 8: Market Was Volatile, But In a Range – YTD Return Flat Chart 9: Realized Volatility Lower Using Alternative Calculation
1,000
1,100
1,200
1,300
1,400
1/3 2/3 3/3 4/3 5/3 6/3 7/3 8/3 9/3 10/3
11/3
SPX
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25
35
45
55
Standard Deriv ation High/Low Range Deriv ation
Last 12-Months Last 4-Months
Realized Volatility of Av erage S&P500 Stock
Note: Different methods of computing realized volatility can lead to alternative conclusions. See page 17 of the Appendix for a detailed explanation. Source: UBS and Bloomberg
However, to be clear, even if 2012 is characterized by high volatility on average, the volatility will likely not be uniform throughout the year, and episodes of both high and low volatility are likely at various times. Investors could seek to initiate long option strategies during periods of complacency and to initiate option selling strategies when fear is elevated.
Another point of consideration is when to initiate such strategies with respect to the level of the underlying security. That is, long option strategies might be initiated when an investor believes either that a security might break out of a range or become very volatile within a range, while option selling strategies would likely be initiated when an investor believes a security will remain within the range, and may be near the middle of the range.
Capitalizing on Changes in Implied Volatility
(longer-dated / vega trading)
We now briefly consider the merits of expressing a view on whether implied volatility will increase or decrease, via trading intermediate to longer-dated options. In the two charts below, we note both that implied volatility is high relative to its history (Chart 10) and that implied volatility remains high throughout the term structure (Chart 11). While the trend in Chart 11 is based more on supply and demand factors than an expectation that volatility will remain unusually elevated for the next decade, in our view the shape of the term structure can provide interesting opportunities.
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Chart 10: Market Volatility Elevated Compared to History Chart 11: Implied Volatility Remains High Into the Future
10%
20%
30%
40%
1/4/96 1/4/99 1/4/02 1/4/05 1/4/08 1/4/11
SPX 1-Year Implied Volatility
24%
26%
28%
30%
32%
Dec-2011 Dec-2013 Dec-2015 Dec-2017 Dec-2019
SPX ATM Implied Volatility (Spot Ref 1,225)
Source: UBS Source: UBS
The fact that implied volatility is historically high and that there have only been a few years within the past 20 years or so where realized volatility has exceeded current implied volatility (shown in Chart 1) would likely lead many to conclude that implied volatility should be sold. However, if uncertainty remains high for any number of existing or future macro concerns, then implied volatility will likely remain firm. We believe implied volatility should be sold. For investors who can trade over-the-counter variance, our recommendation is to sell forward starting variance swaps, to eliminate near-term gamma exposure. For investors who prefer using listed options, a similar volatility view can be expressed via selling strangles, although this does leave the seller exposed to stock volatility.
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Directional Option Strategies
Many investors employ options to express a directional stock view. In the environment of continued high absolute levels of implied volatility, we believe it is possible to identify more option selling strategies, as opposed to strategies involving option buying. Further, given the UBS strategy view that significant macro headwinds may persist next year, our preference is to sell calls, as opposed to puts. We summarize the criteria for each option strategy in the below table, and describe the rationale in the section that follows.
Table 1: Option Strategy Summary Rationale
Option Strategy 2012 Stock View Volatility Stock price in 52-Week
Range
Sell strangle No preference High Middle
Overwrite No preference High Upper
Buy-write Most preferred High Lower
Sell put Most preferred High Lower
Buy call Most preferred Low Lower
Buy put Least preferred Low Upper
Buy call & sell put Most preferred High skew Lower Note: Stock view based on combination of sector, industry and analyst view, see methodology on page 9. Volatility based both on absolute (i.e., level of 12-month implied volatility) and relative (i.e., relationship between implied and realized volatility). Stock price in 52-week range is current stock price ranked relative to the high-low range. 100% = stock is at top of range and 0% = stock is at bottom of range. Skew (i.e., relationship between put and call implied volatility) was also used in determining various option strategies, where high put volatility is associated with put selling and low call implied volatility is associated with call buying. Source: UBS
Table 2: Option Strategy Detailed Rationale
Option Strategy Detailed Rationale
Selling strangles (sell call and put) Pursuant to our earlier discussion of this strategy, we consider selling both puts and calls (i.e., strangle), for stocks where the analyst has no strong preference in 2012 and are in the middle of their 2011 price range.
Overwriting (sell calls) Overwriting (or selling upside calls) is ideal for stocks without a strong 2012 preference that are in the middle to upper end of their 2011 price range.
Buy-writing
A strategy of buying a stock and simultaneously selling an upside call (buy-writing) is well suited for stocks that are preferred by our analysts in 2012 and where the stock is in the middle to lower end of its 2011 price range While, under normal market conditions, investors do not typically wan to limit the upside of a preferred holding, in the current environment with presumed macro headwinds, selling a call allows an above average premium to be collected (given elevated implied volatility levels at present) and this premium can help buffer against minor stock declines.
Put selling While there is concern of continued and/or increased macro headwinds, we also consider selling puts for stocks that are most preferred by our analysts in 2012 and that are at the lower end of their 2011 price range.
Buying calls or puts While we are open to buying calls and puts, our method of using scores and volatility considerations did not yield any cases we felt were compelling enough to recommend. Therefore, we show selected cases later in this report as illustrative only.
Buying calls and selling puts (risk reversal) For stocks which our analysts prefer most in 2012 and that have high “skew” (put implied volatility is much higher than call implied volatility). While we considered buying calls and selling puts, our method of using scores and volatility considerations did not yield any cases we felt were compelling enough to recommend.
Source: UBS
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Stock Outlook Scoring Methodology Uses Both Macro and Micro
Given the importance of a fundamental outlook as part of our rationale for recommending 2012 option strategies, we devised a scoring methodology that goes beyond using our analyst’s rating and 12-month price target. Instead, we blended the macro outlook of our equity strategists with the micro preferences of our fundamental analysts for nearly 400 UBS-covered stocks with liquid options as illustrated in the figures below.
Figure 1: 2012 Stock Outlook Based on Both Macro and Micro View
Sector
Industry
Stock
Weight UBS Source
25% Analyst Preference
35% Global Sector Head (Analyst) 2012 Outlook
40% Global/U.S. Equity Strategist Weights
Recommendation Score
Overweight / Most Preferred
Neutral / No Preference
Underweight / Least Preferred
1.0
0.5
0.0Sector
Industry
Stock
Weight UBS Source
25% Analyst Preference
35% Global Sector Head (Analyst) 2012 Outlook
40% Global/U.S. Equity Strategist Weights
Recommendation Score
Overweight / Most Preferred
Neutral / No Preference
Underweight / Least Preferred
1.0
0.5
0.0
Note: Analyst stock and industry preferences as well as sector weights taken from 2012 Global Sector Research Outlook and other recent 2012 outlook reports. Effective analyst weighting 60% (35% + 25%) vs. 40% from strategists. Source: UBS
Table 3: Scoring Examples
Stock Industry Sector
Intel Corporation INTC Semiconductors Technology
Recommendation Most Preferred Most Preferred Overweight
Score 1.0 1.0 1.0
Weight 25% 35% 40%
Total Score 1.00
Stock Industry Sector
Computer Sciences Corp. CSC IT Services Technology
Recommendation Least Preferred Least Preferred Overweight
Score 0.0 0.0 1.0
Weight 25% 35% 40%
Total Score 0.40 Note: Analyst stock and industry preferences as well as sector weights taken from 2012 Global Sector Research Outlook and other recent 2012 outlook reports. Source: UBS
Industries and stocks that were specified as most or least preferred in UBS 2012 outlook pieces were scored accordingly, while those that were not specified
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were assigned a “no preference” by default. Analyst stock ratings were not incorporated.
Table 4: Sector and Industry Score
Score Definition Sectors Industries
1.0 Overweight / Most Preferred Health Care, Staples, Tech
Aerospace & Defense, Beverages, Capital Markets, Commercial Banks, Communications Equipment, Construction & Engineering, Energy Equipment & Services, Food & Staples Retailing, Hotels Restaurants & Leisure, Household Durables, Internet & Catalog Retail, Internet Software & Services, Machinery, Metals & Mining, Semiconductors
0.5 Neutral / No Preference Discretionary*, Energy, Industrials, Materials, Telecom
Air Freight & Logistics, Airlines, Biotech, Chemicals, Computers & Peripherals, Containers & Packaging, Telecom Services, Electric Utilities, Electrical Equipment Instruments & Components, Health Care Providers & Services, Household Products, Independent Power Producers & Energy Traders, Industrial Conglomerates, Insurance, Leisure Equipment & Products, Media, Multi-utilities, Oil Gas & Consumable Fuels, Personal Products, REITs, Road & Rail, Software, Specialty Retail, Textiles Apparel & Luxury Goods, Tobacco, Trading Companies & Distributors, Wireless Telecom Services
0.0 Underweight / Least Preferred Financials, Utilities Automobiles and components, Diversified Financial Services, Food Products, Heath Care Equipment & Supplies, Health Care Tech, IT Services, Life Sciences Tools & Services, Paper & Forest Products, Pharmaceuticals
*Blend of Sector weighting from equity strategists Jonathan Golub and Jeffrey Palma. Source: UBS
Scores for close to 400 UBS-covered stocks with option liquidity are displayed in the Appendix of this report.
Option Trades We will highlight trades at the Index and sector level first, and then recommend single stock option trades for many of the option strategies discussed above. Note that all option prices exclude fees and/or commissions.
Index and Sector Trades
In light of our strategist’s view of a potential range-bound market in 2012, it would seem natural for investors to contemplate the maximum return that could be achieved by accurately projecting the range for the Index, a sector or stock for next year. Thus, we highlight some strangle selling trades for both the SPX and for selected sectors on which our strategists are neutral, namely Discretionary, Energy, Industrials and Materials. Irrespective of whether an investor would consider initiating such strategies, it is interesting both to note the premiums collected and to compare the breakeven levels to the 52-week low and high.
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Table 5: Index / Sector Trade Examples – Selling Strangles
Materials 41.28 Call Jan-13 40 116.3% 1.90 5.5% 27.3% 0.36 43.46 126.3% Note: Premiums and implied vol are bid side, delta is mid. Breakevens: for call leg it is call strike plus sum of put and call premium and for put leg it is put strike minus sum of put and call premium; data as of 5 December 2011. Source: UBS and Bloomberg
Stock Trades
In Tables 7-10, we present stock-specific recommendations for each of the option strategy types above: selling strangles, call overwriting, buy-writing and put selling. We were unable to identify any good call buying opportunities, but present our screen results in Table 11 as illustrative examples for interested investors. We also were unable to identify attractive put selling or risk reversal trades, and do not highlight data for these strategies.
Table 6: Jan ‘13 Stock Option Strategy Recommendation Summary
Sell Strangles Overwrite Buy-Write Sell Put Buy Calls, Puts, or Risk Reversals
ADBE HON AFL HON AEM FLR AEM None Recommended
AMZN NE AMZN JCI BHI HOT BHI
CAM NUE CAT MON BRCM MRVL DE
CAT ORCL CMG NUE EBAY RIG FCX
CE OXY COH OXY FCX VECO FLR
EOG TSO EOG PXD RIG
ETN VMW ESV SBUX SWKS
HOG SLB Source: UBS
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Table 7: Stock Option Strategies – Sell Jan ‘13 Strangles (sell call and sell put)
Call 129.9% 6.2% 35.6% 0.32 141.0% Note: Black Sky is valuation our analyst expects shares could go under severe recessionary conditions, 12-month target is our analysts’ base-case price target. Premiums and implied vol are bid side, delta is mid. Breakevens: for call leg it is call strike plus sum of put and call premium and for put leg it is put strike minus sum of put and call premium. Data as of 5 December 2011. Source: UBS and Bloomberg
Average 0.55 120.7% 8.0% 35.3% 0.38 128.7% Note: 12-month target is our analyst’s base-case price target. Premiums and implied vol are bid side, delta is mid. Breakeven: call strike plus premium. Data as of 5 December 2011. Source: UBS and Bloomberg
Average 0.84 130.3% 7.8% 40.3% 0.35 38.1% Note: 12-month target is our analysts’ base-case price target. Premiums and implied vol are bid side, delta is mid. The strategy’s maximum return occurs when the stock reaches the price indicated (Max Return Stock Price column), % return in this case also shown. Data as of 5 December 2011. Source: UBS and Bloomberg
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Table 10: Stock Option Strategies – Jan ‘13 Sell Puts
Average 0.81 73.1% 8.6% 51.5% -0.21 64.5% Note: Black Sky is valuation our analyst expects shares could go under severe recessionary conditions. Premiums and implied vol are bid side, delta is mid. Breakeven: put strike minus premium. Data as of 5 December 2011. Source: UBS and Bloomberg
Many investors may have interest in buying calls with longer-term maturities to position for a recovery in beaten down, but still favored stocks. While we note for many of these stocks implied volatility is not low in this environment, we think a case can be made that for such instances, one should evaluate the premium relative to the return expectation for the stock, as opposed to the level of implied volatility.
Screens can easily identify such stocks, where far from-the-money calls can be evaluated for purchase. Our systematic approach however, did not yield any compelling candidates for call buying. Nevertheless, for informational purposes only, we wanted to show our results. Note the average premium is high (11.6%) for an average 132% strike, making the breakeven above 143%.
Table 11: Stock Option Strategies – Buy Jan ‘13 Calls. Illustrative only, we are not recommending these trades.
Note: 12-month target is our analysts’ base-case price target. Premiums and implied vol are offered side, delta is mid. Call breakeven: call strike plus premium. Data as of 5 December 2011. Source: UBS and Bloomberg
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Thoughts on Trade Implementation First, given the presumed high volatility in 2012, more active (as opposed to passive) investing may be required and/or appropriate. To that end, and as we have advocated previously, if an investor believes that a range can roughly be defined, then some trades are better suited to be initiated at the bottom end of the range, while others are more appropriate for the top end of the range. For example:
Bottom: put selling, call/call spread buying and buy-writing
Top: call selling, put/put spread buying and overwriting
Also, with respect to selling strangles, in a volatile market both options do not need to be sold simultaneously. In fact, if one expects a choppy market then a put can be initiated on a correction, while the call can be sold after a rally.
While the definition of a range is only completely accurate in hindsight, and while no investor can realistically predict both the bottom and top of a range we think it is worth noting that several times since August large quick market moves would have allowed the opportunity to “leg” into a short strangle. For example, consider the following ranges within a short time horizon, based only on SPX closing prices:
7.6% range from Aug. 8 (1,119) and Aug. 15 (1,204)
11.8% range from Oct. 3 (1,099) and Oct. 14 (1,225)
The above examples illustrate that a patient (and perhaps fortunate) investor could possibly use market volatility for the advantageous purpose of initiating a wider strangle than possible if one was to initiate both options at the same time. Especially for strangles sold with longer maturities (e.g. 1+ years) an investor could be more patient in initiating each leg at the appropriate market level.
Chart 12: Entry/Exit Levels for Strategies in a Range-bound Market
1,000
1,100
1,200
1,300
8/3 9/3 10/3 11/3
SPX Sell Calls (ov erw rite), buy puts or put spreads
Buy -w rite, sell puts, buy calls or call spreads
Source: UBS and Bloomberg
Given presumed high volatility in 2012, more active (as opposed to passive) option strategies may be required and/or preferable
Investors might consider “legging” into short strangles
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Portfolio Hedging Lastly, we briefly address portfolio hedging strategies.
Starting with the market recovery in spring 2009, following the Lehman bankruptcy in fall 2008, investor interest in inexpensive portfolio hedges has intensified. Since the beginning of 2010 there has been an additional focus and steady interest for the past two years, on obtaining “disaster insurance” (i.e., “tail risk” hedges) to protect against a market crash.
Not surprisingly, given the almost universal investor interest in portfolio hedges, puts have remained expensive. Further, in periods of high correlation during some periods since post-Lehman, such as since August, some investors have clamored for fast portfolio protection via buying Index (i.e. S&P) puts, thus keeping the cost of portfolio hedging high.
Given the presumed continued macro uncertainty in 2012, it is unlikely that put skew will decline significantly anytime soon. However, our advice for portfolio hedging for 2012 is to consider hedging to be an active, as opposed to passive (i.e., “set and forget”) endeavor. That is, to capitalize on the presumed choppy market action by seeking to initiate hedges after stocks have rallied, while fear has temporarily subsided, and to liquidate such hedges after market correction, when fear is elevated. This is just another way of saying we think investors should buy hedges low and sell hedges high – which is easier said than done, but in our view a legitimate strategy nonetheless.
Portfolio hedges, especially “disaster insurance”, have been in vogue since 2010
Continued investor demand for hedges has kept hedging costs elevated
For 2012 we advocate active hedging – initiating hedges on market rallies and liquidating hedges post corrections
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Appendix Detailed Explanation of Charts 4-9 Charts 4 and 5 In Chart 4, in consideration of a decision to sell strangles now through 2012, we show how similar trades initiated around the same time last year, with a January 2012 expiration, would have performed throughout 2011 (with the standard caveat that past performance is not necessarily indicative of future results). For illustrative purposes, we show two trades, an SPX 1050/1325 strangle sold at the December intraday low of 1187 on December 1 and a 1125/1400 strangle sold at the December intraday high of 1263 on December 29. Given that during December 2010 volatility was benign and that we expect numerous episodes of high volatility next year, in Chart 5 we show how a similar strangle selling strategy, initiated on August 29, during a brief calm moment within the highly volatile August – October period, would have performed since then. Note how in both charts the initial P&L was rocky, with negative mark-to-market values at times, and only later on did the trades start becoming profitable. All trades were presumed to be sold at mid-market levels, and are exclusive of fees and/or commissions. Charts 6 and 7 The above charts are meant to approximate the experience of long gamma, via buying options, presumably a straddle (i.e., buy both at-the-money put and call), each day in 2011, actively re-balancing the position delta and holding the options to expiration. We compare the implied volatility on a given day to the “lagged” realized volatility one month later. That is, 1-month implied vol on February 5 is compared to 1-month realized vol on March 5, the latter approximating the level of volatility assumed over the life of the option term. In Chart 6 we show the average realized minus implied vol difference, for all of the days in 2011 so far, for the average of all S&P500 stocks. Note that the results for the SPX Index, although not shown here, are strikingly similar. In Chart 7 we show the realized minus implied difference for SPX over time. In both charts, note how the average difference for 2011 YTD is positive, but that this is mostly the case since August. All trades were presumed to be sold at mid-market levels, and are exclusive of fees and/or commissions. Charts 8 and 9 With respect to Chart 9, various methods exist to compute realized volatility, and one distinction is with respect to the sampling frequency of the data. The most common approach is to use daily closing prices, but weekly, monthly, quarterly or even to take only the high and low prices over the past year can be used. If the realized volatility using less frequent sampling is lower than the volatility using daily sampling this generally indicates that the stock has been volatile, but within a defined range. By contrast, a higher realized vol number using less frequent sampling generally indicates that a stock has been trending. As seen in Chart 9, the realized vol computed by using only the high and low prices over the past year are much lower than the realized vol as computed using the standard approach. We interpret this to mean that passive option selling strategies would have broadly worked in 2011. If 2012 plays out in similar fashion to 2011 then we think such strategies might be profitable again next year as well.
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Stock Scores Table 12: Scores based on Sector, Industry and Analyst Preferences. Part 1 of 6. Weights: stock 25%, industry 35%, sector 40%.
Ticker Sector Industry Scores Ticker Sector Industry Scores
Sector Industry Stock Total Sector Industry Stock Total
A Health Care Life Sciences 1.0 0.0 0.5 0.53 APC Energy Oil & Gas 0.5 0.5 1.0 0.63
AA Materials Metals & Mining 0.5 1.0 0.5 0.68 ARO Discretionary Specialty Retail 0.5 0.5 0.0 0.38
ZMH Health Care HC Equipment 1.0 0.0 0.5 0.53 Source: UBS
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Option Trade Risks
Trades presented in this report have expiration dates of December 2012 and January 2013. While such option trades do not need to be held through expiration, it should be noted that longer-term options generally have lower liquidity than shorter maturity options. Thus, bid/ask spreads are presumed to be wider, making it likely more expensive to liquidate prior to expiration. Also, while recommended trades are not required to be held to expiration, the general idea behind these trades is that they are not intended to be liquidated in the near term. Thus, we believe they are better suited to a more patient, low turnover investment style, than for investors who prefer high turnover strategies. However, given the numerous ongoing macro risks presumed to continue to impact markets in 2012, which could cause significantly high volatility episodes next year, at potentially large mark-to-market swings for some of the recommended strategies may test the nerves of even calm investors. Keep in mind that such longer-term trades carry more exposure to changes in implied volatility than shorter-term options, and thus, an investor is exposed to both price and implied volatility changes. In our view, this is an important consideration for investors who typically trade shorter-term options. Also, given a roughly one-year horizon for these trades, many factors can influence the outlook for a given stock over 2012, with periods of bearishness and bullishness at different times.
During the life of an option, a mark-to-market loss may result either if implied volatility increases for options sold or if implied volatility decreases for options purchased. Margin is required to be posted for an uncovered option sold.
For strangles sold, at expiration investors may incur losses if the stock trades above the upper breakeven level, or below the lower breakeven level. At expiration, an investor would be required to buy the stock if it is below the put strike and be required to sell the stock if it is above the call strike. Also, we note an increase in implied volatility may cause a mark-to-market loss in the trade, during the life of the option, assuming that other variables remain constant.
For covered calls sold, at expiration the breakeven equals the call strike plus premium.
Both for overwriting and buy-writing, at expiration if the stock is above the call-away level, an investor would have been better off not having sold the call, as the maximum return is capped at this level (lost additional profit vs. just being long the stock). A risk specifically associated with intermediate-term call selling is that the maximum return is capped for longer, as opposed to if the option maturity were more near-term. Thus, there is more time for either the overall market or stock view to improve.
For uncovered puts sold, the breakeven is strike minus premium and the maximum loss is also strike minus premium. An investor is required to buy the stock if it is below the put strike.
For calls purchased, at expiration the breakeven is call strike plus premium and the maximum loss is the premium paid.
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Statement of Risk
Investing in options involves numerous risks. Such risks include, but are not limited to, the following; a long option position- is negatively impacted by a decrease in implied volatility, lack of movement in the underlying stock or Index and the passage of time. A short option investor is negatively impacted by an increase in implied volatility, a large directional movement in the underlying stock or Index and the lack of the passage of time. For options purchased the maximum loss is the premium. For an uncovered call sold the maximum loss is unlimited, while for an uncovered put sold the maximum loss is put strike minus premium. For uncovered options margin must be posted. Because uncovered option selling involves significant risks this strategy should be under taken only by sophisticated investors. Complex option strategies involve either the simultaneous purchase or sale of multiple options or the simultaneous purchase and sale of numerous options, such as spreads or collars. Their pay off profile and risks can be complicated, and should only be undertaken by sophisticated investors. Complex option strategies can often be broken down into individual component options, and their risks can be identified and analyzed. Complex strategies may have limited or unlimited loss potential, and in cases where uncovered options are sold margin is required to be posted. Also see options risk disclosure within the Required Disclosures section of this document.
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Each research analyst primarily responsible for the content of this research report, in whole or in part, certifies that with respect to each security or issuer that the analyst covered in this report: (1) all of the views expressed accurately reflect his or her personal views about those securities or issuers and were prepared in an independent manner, including with respect to UBS, and (2) no part of his or her compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed by that research analyst in the research report.
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Required Disclosures This report has been prepared by UBS Securities LLC, an affiliate of UBS AG. UBS AG, its subsidiaries, branches and affiliates are referred to herein as UBS.
For information on the ways in which UBS manages conflicts and maintains independence of its research product; historical performance information; and certain additional disclosures concerning UBS research recommendations, please visit www.ubs.com/disclosures. The figures contained in performance charts refer to the past; past performance is not a reliable indicator of future results. Additional information will be made available upon request. UBS Securities Co. Limited is licensed to conduct securities investment consultancy businesses by the China Securities Regulatory Commission.
UBS Investment Research: Global Equity Rating Allocations
1:Percentage of companies under coverage globally within the 12-month rating category. 2:Percentage of companies within the 12-month rating category for which investment banking (IB) services were provided within the past 12 months. 3:Percentage of companies under coverage globally within the Short-Term rating category. 4:Percentage of companies within the Short-Term rating category for which investment banking (IB) services were provided within the past 12 months. Source: UBS. Rating allocations are as of 30 September 2011. UBS Investment Research: Global Equity Rating Definitions
UBS 12-Month Rating Definition Buy FSR is > 6% above the MRA. Neutral FSR is between -6% and 6% of the MRA. Sell FSR is > 6% below the MRA. UBS Short-Term Rating Definition
Buy Buy: Stock price expected to rise within three months from the time the rating was assigned because of a specific catalyst or event.
Sell Sell: Stock price expected to fall within three months from the time the rating was assigned because of a specific catalyst or event.
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KEY DEFINITIONS Forecast Stock Return (FSR) is defined as expected percentage price appreciation plus gross dividend yield over the next 12 months. Market Return Assumption (MRA) is defined as the one-year local market interest rate plus 5% (a proxy for, and not a forecast of, the equity risk premium). Under Review (UR) Stocks may be flagged as UR by the analyst, indicating that the stock's price target and/or rating are subject to possible change in the near term, usually in response to an event that may affect the investment case or valuation. Short-Term Ratings reflect the expected near-term (up to three months) performance of the stock and do not reflect any change in the fundamental view or investment case. Equity Price Targets have an investment horizon of 12 months. EXCEPTIONS AND SPECIAL CASES UK and European Investment Fund ratings and definitions are: Buy: Positive on factors such as structure, management, performance record, discount; Neutral: Neutral on factors such as structure, management, performance record, discount; Sell: Negative on factors such as structure, management, performance record, discount. Core Banding Exceptions (CBE): Exceptions to the standard +/-6% bands may be granted by the Investment Review Committee (IRC). Factors considered by the IRC include the stock's volatility and the credit spread of the respective company's debt. As a result, stocks deemed to be very high or low risk may be subject to higher or lower bands as they relate to the rating. When such exceptions apply, they will be identified in the Company Disclosures table in the relevant research piece. Research analysts contributing to this report who are employed by any non-US affiliate of UBS Securities LLC are not registered/qualified as research analysts with the NASD and NYSE and therefore are not subject to the restrictions contained in the NASD and NYSE rules on communications with a subject company, public appearances, and trading securities held by a research analyst account. The name of each affiliate and analyst employed by that affiliate contributing to this report, if any, follows. UBS Securities LLC: Mitchell S. Revsine; Brian Russo.
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Company Disclosures
Company Name Reuters 12-mo rating Short-term rating Price Price date Adobe Systems Inc.4a, 6c, 7, 16 ADBE.O Buy N/A US$27.91 05 Dec 2011 Advanced Micro Devices16, 20 AMD.N Buy (CBE) N/A US$5.76 05 Dec 2011 AFLAC Inc.6b, 7, 16 AFL.N Neutral N/A US$44.43 05 Dec 2011 Agnico-Eagle Mines Ltd.16 AEM.N Buy N/A US$42.69 05 Dec 2011 Amazon.com Inc16, 18j AMZN.O Neutral N/A US$196.24 05 Dec 2011 Baker Hughes Inc.2, 4a, 5a, 6a, 6b, 6c, 7,
16 BHI.N Buy N/A US$54.70 05 Dec 2011
Broadcom Corporation16 BRCM.O Buy N/A US$30.42 05 Dec 2011 Cameron International Corp.2, 4a, 6a,
VMware, Inc5a, 16 VMW.N Buy N/A US$97.09 05 Dec 2011
Source: UBS. All prices as of local market close. Ratings in this table are the most current published ratings prior to this report. They may be more recent than the stock pricing date
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(or the prior month`s end if this report is dated less than 10 working days after the most recent month`s end). Options, structured derivative products and futures are not suitable for all investors, and trading in these instruments is considered risky and may be appropriate only for sophisticated investors. Past performance is not necessarily indicative of future results. Various theoretical explanations of the risks associated with these instruments have been published. Prior to buying or selling an option, and for the complete risks relating to options, you must receive a copy of "The Characteristics and Risks of Standardized Options." You may read the document at http://www.optionsclearing.com/about/publications/character-risks.jsp or ask your salesperson for a copy.
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