Jobs number takes away some market uncertainty

by Wayne Ferbert on August 5th, 2013

As a regular reader of this blog, you know that we update the cost of hedging every week. The cost to hedge is an analysis of the options chain prices for buying put protection on the broad market indexes. We prefer to buy our protection when it is at its cheapest prices – so we monitor this closely.
The cost of protection is really driven by the implied volatility of the future market movements. ‘Implied’, in this case, is really a price driven context. If Mr. Market thinks the future market has a lot of uncertainty, then the cost of protection goes up. If there is less uncertainty, the cost of protection goes down.
This concept of uncertainty is really the best way to think about the time value in any option price. A call or a put option has a strike price and an expiration date. The more time value you pay to buy that option, the more the ‘implied’ uncertainty about the likelihood that the option finishes in the money at the expiration date.
Last Friday, we watched the markets closely as the July jobs numbers were released. The numbers were lukewarm – but positive – again. The market reaction was slightly down on the news and remained down thru the day.
Usually a downward trend in the market will send the Implied Volatility in the market upwards. The reason is what we call the ‘fear premium’ that gets embedded in options when the markets start to fear a meaningful pull back. Short-term pull backs even when shallow can make the fear premium rise.
But on Friday, the August expiration options that are near the money actually had their Implied Volatility pull back. In fact, really the whole August chain had the IV pull back as reflected in the prices. These August expirations basically had two weeks to go before expiration.
What happened on Friday was a classic example of a little bit of uncertainty being removed from the August expiration options. Think about it this way: on Thursday night, if you held the option, you had a material news report about the economy being released the next morning. That jobs report is closely watched and it can move the market. And you don’t know what it is going to say – no one does.
After it comes out, everyone knows the outcome – and a little more uncertainty about the things that can move the market is removed.
Now, with only two weeks to go before expiration and the jobs number behind us, there are not a lot of economic data releases in the next two weeks that might move the market. In fact, when you look at the economic calendar, I challenge you to find me one economic data release that is likely to move the market. There are no Fed notes or scheduled Fed talks that will likely move the market.

This is the first two weeks of August – a notoriously slow market period as Wall Street takes a vacation. Plus, most of the largest Fortune 500 companies have already announced earnings this quarter – making the likelihood of an earnings surprise shaking the market an unlikely event. In fact, the Fed announcements and the jobs reports are sort of the S&P500’s earnings announcements. They are the announcements that tend to move the markets – but once announced, typically, some uncertainty is reduced.
Uncertainty is a big part of the time value in the options chains – especially the near month options chains. For those of you that follow our credit spread strategy, the higher the IV in the market, the more likely we can find a 3-week trade that can generate our desired returns. But the low IV is being driven by a limited amount of uncertainty in the broad market – at least from the Wall Street trader’s point of view. So, we have not found our desired trade for the quarter yet. If we have a spike in volatility in the coming weeks, we will hopefully find our entry point.

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