On Tuesday the Dow industrials traded with a 260-point range in reaction to the FOMC's policy statement, which left interest rates unchanged for the ninth consecutive time. And for the ninth time in a row the CBOE's volatility index [VIX] closed above a measure of 20. It wasn't the failure to lower rates that caused turmoil in the markets. Indeed turmoil actually subsided Tuesday once investors and traders honed in on the words that the Fed communicated.
Many people had looked for signs of an easing of monetary policy sometime ahead of the year-end. However, the Fed shook its head and pointed to yet moderate growth expectations ahead, coupled with its obsession with a fear that inflationary pressures might still not moderate moving ahead. One has to wonder just what will happen to core inflation when the housing market finally recovers.
All said and done yesterday, stocks rallied and there has been a positive follow-through around the world. The yield on the 10-year note has risen from 4.69 percent on Friday to 4.81 percent after the announcement. Expectations for an October interest rate cut have been pared back from as high as 84 percent earlier this week to 58 percent today according to the futures market. Judging by an early rally in stock index futures too, we're likely to refocus on economic growth prospects and corporate earnings.
The recent surge in volatility is showing signs of losing its luster, and that makes perfect sense too. Despite demands and screams from Jim Cramer for the Fed to open the discount window, and despite the diagnosis from PIMCO's Bill Gross that monetary policy remains restrictive, investors appear to have calmed down having read the Fed's message. The economy isn't rafting headlong without a paddle for the edge of the waterfall with no tree branch within reach. The immediate kneejerk lower for stocks and flight to bonds in the aftermath of the statement have been reversed.
Overnight, interest rates in Australia rose to an 11-year high. The Bank of England's latest quarterly assessments of the economy and prospects for the path of inflation have iced the cake for a further rate rise. Both serve to remind us that all is well for growth and that the world isn't falling apart at the seams. As such both the Canadian and Australian dollars have risen today – both healthy barometers for commodity demand. And earlier this week the demand for puts to protect currency investors against further Australian weakness rose to its highest in some time.
Perhaps risk aversion is yesterday's story. Traders will very likely test the waters by selling the VIX below a reading of 20 today. That doesn't mean that the fear factor has left the building. It simply means it's lurking on a different floor.
VIX – Volatility is off 8.4 percent at 19.75 in the CBOE Volatility index while the VXN, measuring implied volatility across the Nasdaq market is 7.8 percent easier at 19.47 after Cisco's earnings.
Trading in VIX futures options is relatively quiet with two prominent trades going through, indicating to us that volatility buyers' rationale is waning. In the August and September series, more than 15,000 contracts have traded at the 25 strike and it's too early to tell whether these are new or closing trades just yet. The August 18 puts were most popular on the bear side trading at an 83 percent higher premium than Tuesday at 0.55.
By 11:50am the Dow Jones industrial average was 0.69 percent higher at 13,595.90. The S&P 500 index was 0.97 percent higher at 1,492.00 while the Nasdaq composite index surged 1.77 per cent to 2,606.71.
The small cap market got especially hurt as equities took a pounding. The Russell 2000 index fell 13.2 percent at the same time as the S&P 500 index declined by 8.2 percent. One theory had it that large volumes of “riskless” spread trades between small and large caps created huge selling of small cap stocks. Hedge funds had been able to go long outperforming small caps while simultaneously selling large caps. When the market reversed, the losses on the former exacerbated selling pressures.
IWM - In the iShares Russell 2000 index open interest on options between the end of last week and yesterday jumped by 11 percent. The number of puts outstanding dwarves the call position by a factor of 2.2 indicating ongoing portfolio hedging. Today shares are once again raging higher with a 2.6 percent gain while the S&P is just 1 percent firmer.
XLF – Financial Select Sector SPDR is also 2.4 percent better off today and of interest once again is the change in options positioning since the selling pressure peaked last Friday. Outstanding call option positions jumped by one quarter to stand at 1.132 million contracts as of yesterday as smart money bought call options. With shares in the ETF at $34.82 or 8.9 percent off the Monday floor at $31.96, we can see a trail of bullish positioning at the August 34 strike where call interest jumped 47,000 lots yesterday to stand at 107,000 contracts. Interest in the September 35 calls has almost doubled to 68,700 lots since Friday, while the 32 calls have seen open interest increase 17 percent at the same time. Meanwhile options implied volatility – a measure of uncertainty – has dropped by around a quarter since last Thursday, falling from almost 40 to 29 percent by midweek. That reading is much more in-line with the historic, albeit elevated reading of volatility on the shares at 23 percent.
CSCO - Shares in Cisco (NASDAQ:CSCO), the world's top computer networking equipment, shot to a nine-month high today, up nearly 6 percent at $31.38 going into the noon hour, after reporting a sixth consecutive quarter of revenue growth in excess of 15 percent and increased its guidance for year-end earnings. Options traders responded by putting nearly 232,000 contracts in play, making it the most heavily traded non-ETF ticker for the day.
Implied volatility on Cisco options, which had peaked yesterday at nearly 37% ahead of earnings, receded more than 10% today as investors took the hale and hearty earnings report as ballast against future price shocks. The current implied volatility reading is now actually a couple of percentage points below the historic level of volatility in Cisco share prices.
The August 30 call, which was heavily trafficked yesterday ahead of earnings, remains the most popular strike in Cisco's option calendar, trading more than 41,675 times this morning to both the bid and the ask. The going price for this contract hit $1.60 today, a full doubling in price in just 2 days. An even cheaper method of acquiring upside front-month exposure in Cisco options is seen in the August 32.50 calls, which are going for a song at $0.20 apiece and have seen volume of more than 27,000 lots trade predominantly to the ask side. Volatility players may be looking to the August 30 straddle, which involves the simultaneous purchase or sale of a call and put in anticipation of volatility price moves. The cost of the August 30 straddle is currently $1.50. The decline in the value of implied options volatility from 37 percent pre-earnings to 26 percent today has caused the straddle price to fall from $1.95 in yesterday's session.
Floor sources reported to us that heavy buying interest in Cisco options had also been seen in two call spreads in the January '08 series, with 10,000 lots trading at the January '07 25/27 call spread at a price of $2.10, and another 10,000 lots trading at the 30/35 call spread in the same month, at a price of 2.35.
CECO – Career Education Corp – Shares in this nationwide vocational and online degree company are down 1.75 percent this morning, ahead of an afternoon Q2 earnings announcement that some analysts expect to trail sector peers including Apollo Group and DeVry. With shares currently trading at $29.54, options traders have put 12,600 contracts in circulation, against 59,625 total open interest. With implied volatility sitting at 55 percent, the market is pricing in 20 percent more volatility in these shares than they have documented in the past – not surprising just ahead of earnings, but a substantial elevation all the same. With premiums favoring the call side, we noted volume of about 4,800 lots at the at-the-money October 30 straddle as traders position for a significant blow to the up or downside in share prices. Today's volume is 10 times the daily average.
BMY – Bristol Myers Squibb - Shares are up 2 percent in early trading at $29.48, one day after the FDA granted a review for its arthritis remedy Orencia, which is already on the market for adults but may soon be marketed to juveniles. With 76,800 option contracts circulating this morning, more than 15 times as many calls are moving as puts. Notable volume is seen in the September calls, where more than 10,800 lots moved at the September 35 strike on premiums up 200 percent today. An additional 16,000 lots traded in the December 35 calls, with premiums up 100 percent on the day.