Options Market Suggests Favorable Outlook On QQQ To Mid-2022

Summary

• QQQ has delivered very high returns in recent years, but slightly lagged the S&P 500 for 2021.
• Valuations on some QQQ components are extremely high.
• The tech-heavy NASDAQ 100 is sensitive to interest rates.
• The market-implied outlook (calculated from options prices) is bullish for QQQ to mid-2022, albeit with elevated volatility.

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NASDAQ:QQQ has delivered impressive gains for 2021, with a total return of 27.4%. The trailing 3- and 5-year annualized total returns 38.1% and 28.4%, respectively. While technology companies have continued to deliver transformative products and services in recent years, the question is whether the market has become too complacent with regard to valuations. This question is closely tied to outlooks for interest rates via the discount factor applied to future earnings. Rising interest rates have an outsized impact on companies for which the share price is primarily determined by expectations of future growth.

For 2021, the S&P 500 slightly outperformed the QQQ. This is consistent with a shifting emphasis on the relative importance of growth potential vs. discount rates. One might also conclude that the market is starting to reflect concerns as to the sky-high valuations of many of the larger NASDAQ components.

In forming my view on market indexes, I rely on the market-implied outlook. The prices of options on an index ETF (QQQ, in this case) reflect the market’s consensus estimate of the probability that the price of the index will rise (call option) or fall (put option) relative to a specific level (the option strike price) between now and when the option expires. By analyzing the prices of call and put options for a range of strike prices, all with the same expiration date, it is possible to calculate a probabilistic price return forecast that reconciles the options prices. This is the market-implied outlook, and represents the consensus view of buyers and sellers or options.

Since 2018, I have written a number of posts discussing the evolution of the market-implied outlook for QQQ. Most recently, on November 10th, the market-implied outlook for QQQ to January 20, 2022 led to my changing my rating on QQQ from bullish to neutral. Given the short-term view, I indicated that I would revisit the analysis around the end of 2021.

Market-Implied Outlook for QQQ

I have calculated the market-implied outlook for QQQ to the middle of March 2022 (using options that expire on March 18, 2022) and to the middle of the year (using options that expire on June 17, 2022).

The standard presentation of the market-implied outlook is in the form of a probability distribution of price return, with probability on the vertical axis and return on the horizontal.

Market-implied price return probabilities for QQQ for the 2.5-month period from now until March 18, 2022 (Source: Author’s calculations using options quotes from ETrade)

The market-implied outlook for QQQ to the middle of March has the characteristic form that I expect to see for a broad market index. There is a well-defined mode (peak probability) that is positive and a fat negative tail. This shape suggests that investors can expect to make money most of the time, in exchange for the potential for substantial losses that occur with fairly low probability. This outlook implies a 60% chance of a positive return between now and March 18, 2022. The peak in probability (aka the mode) corresponds to a price return of +4.4% and the standard deviation (volatility) is 11.2% (24.8% annualized volatility). The ratio of the mode return to the standard deviation is 39% (4.4%/11.2%). I use this ratio as a metric of the risk-return trade off and a value this high is quite attractive.

The market-implied outlook to the middle of June has a peak in probability corresponding to a price return of +6.8% and the standard deviation in return is 17.2% (25.5% annualized) for a mode-to-standard-deviation ratio of 40%. There is a 59% probability of having a positive price return over this period, according to the market-implied outlook.

Market-implied price return probabilities for QQQ for the 5.4-month period from now until June 17, 2022 (Source: Author’s calculations using options quotes from ETrade)

Summary

The market-implied outlook for QQQ looks bullish for the first half of 2022. The expected volatility is about 25% (annualized). For context, the trailing 3- and 5-year annualized volatilities for QQQ are 18.7% and 17.2%, respectively. The options market is pricing in higher volatility than we have experienced in recent years, but the risk-return value proposition looks attractive.

Analyst’s Disclosure: I/we have a beneficial long position in the shares of SPY either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.