What if the “risk on / risk off” market environment comes to an end, even for a little while? This article explores a trade designed to profit from that possibility.
The CBOE Implied Correlation Index got a lot of attention around the blogosphere and on Twitter last week, following Tuesday’s intraday spike to 103 and closing value above 80. Regular readers of my posts here are already familiar with the index, so I won’t delve into a thorough explanation except to mention the basic notion – that implied correlation tells us what the options markets are implying will be the degree to which stocks (in this case, the 50 largest S&P 500 components) move together as one. Just as implied volatility is an estimate of what future volatility will be, so implied correlation is a prediction about likely future movement of stocks together.
KCJ, the index of SPX component options expiring in January 2012, is not far from its all-time closing highs. Like volatility, implied correlation tends to revert lower toward a long-term mean once the cause of the high correlation dissipates. If we get some lasting clarity on the European sovereign debt situation, I expect KCJ to fall back to 65 or lower. How will that affect stocks and options? Well, we will see individual stocks and market sectors begin to move independently again – based on fundamentals, investor sentiment, and maybe even technicals.
I think a bet on declining correlation is a great move right now because the upside to implied correlation is limited and the downside is extensive. Think about it: stocks can only become socorrelated – there’s a natural ceiling at 1.00. My idea is to find a stock that has shown a lot of long-term independence from the S&P 500, but has acted like the index in recent weeks or months. Our trade will be to buy a straddle on the individual stock and sell a straddle on the index, on the expectation that correlation will decline during the life of the trade. A best-case scenario would be one in which the index doesn’t move very much but the individual stock moves a lot, generating time-decay gains for the short straddle and long-gamma gains for the long straddle. The worst case would be that the opposite happens (the index jumps in one direction and the stock goes nowhere), but that’s not likely to happen since we will be trading an issue that has already demonstrated a recent affinity for index-like behavior. If correlations stay high and both assets move together, our expected loss is nominal.
I screened a universe of equities meeting an options liquidity criterion, and looked for stocks whose one-year SPDR S&P 500 ETF (SPY) correlation was > 0.90 and whose five year correlation was as low as possible. Several companies stood out, and I’ve sorted them into the attached table.
Ideally, I’d like to trade all of these in small size versus an SPX straddle equal to the sum of the values of the long straddles. That way, one or two uncooperative names wouldn’t tank the whole position. Since that would be a bit too unwieldy for our model portfolio here at OP, let’s be content with one index position and one stock straddle. The nice thing about this trade is that it doesn’t require active management. We will use longer-dated options to give the thesis time to play out, and as expiration gets closer it will be relatively clear whether the trade worked or not. Occidental Petroleum (OXY) is an energy company – incidentally, one of the better ways for U.S. investors to get Brent crude exposure that I’m aware of – and has no business tracking the broad market index under normal circumstances. We’re doing this trade on a SPY/OXY ratio of 3:4 to reflect current share prices.
The trade idea is to sell to open the SPY January 2012 125 straddle at $12.09 three times and buy to open the OXY January 2012 95 straddle for $14.20 four times.
This article originally appeared on TheStreet.com and is reprinted with permission.