Analysis: Correlation and the Debt Ceiling

To know what equity traders are thinking, the two most important sources of information to watch are 1) the prices they pay for stocks and 2) the prices they pay for insurance on those stocks. Interpreting price movements can be tricky, and instead of following chart patterns I like to watch the realized volatility of stock returns and the correlation of returns among stocks and indexes. "The prices they pay for insurance" is another way of referring to option prices, and two key ways to interpret option price changes are to look at changes in implied volatility and in the term structure of implied vol. Those four indicators - realized vol, correlation, implied vol, and term structure - are probably the most meaningful signals of what's happening in the market.

Let's review what each of those signals are saying right now as the debt ceiling crisis intensifies:

1) Realized volatility: is still low, because even though investors are starting to get nervous, stocks just haven't moved very much on a daily closing basis. The one month standard deviation of S&P 500 daily returns is less than 10%!

2) Implied volatility: we looked at this in " VIX and the Debt Ceiling," noting that implied vol has been rising and can be expected to stay high, especially relative to realized vol, while the political situation persists.

3) IV term structure: in two recent posts at Condor Options ( 1, 2), I take a pretty thorough look at term structure and especially how unusual it is to see such a flat term slope while realized vol is low. Historically, this situation justified a bullish bias, since median returns one week and one month later were much better than normal, but of course the risk to a debt ceiling failure is not reflected in those historical statistics.

4) Correlation: the more investors focus on big-picture risks, the more stocks tend to move together. So far, we're not seeing fear creep into either the realized correlation among stocks, or in the future correlation implied by option prices. First, here is the realized correlation of S&P 500 constituents to the index:*



S&P 500 Average 1 Month Stock Correlation. Source: Condor Options

There's obviously not much concern evident yet, even at a short one month look back. I expect this estimate to rise this week, but so far it doesn't look like debt ceiling worries are dominating stock selection. We can also look at the correlation implied for the future based on option prices. An updated chart is attached.**



S&P Implied Correlation Indexes. Source: CBOE, Condor Options

Again, there has been a small uptick in implied correlation lately, but nothing remarkable at all. Note that the index for January 2014 will reach the end of its tenure in just a few weeks, so you should expect large movements there, similar to the way an option has more gamma near expiration. The January 2015 index will be more stable, and that's where I would look for any serious sign of increased implied correlation.

In sum, we have modest implied volatility, high (flat) IV term structure, and low correlation and realized volatility. It is already pretty expensive to hedge equity risk, but not so expensive that there are major contrarian trades to make. A wait-and-see attitude seems the most appropriate one. We have been reducing exposure to short volatility trades (and not adding new ones) and will be content to watch for now.

* The S&P Average 1 Month Stock Correlation is the mean value of the most recent one month correlation of each S&P 500 constituent's returns with the returns of the index. A high average value indicates that index constituent returns are determined more by broad market factors than by individual stock fundamentals.

** The CBOE S&P 500 Implied Correlation Indexes are estimates of the average correlation of the stocks that comprise the S&P 500 Index (SPX). Using SPX options prices and the prices of options on the 50 largest stocks in the S&P 500 Index, the indexes track the relative cost of SPX options compared to the price of options on individual stocks.

OptionsProfits can be followed on Twitter at twitter.com/OptionsProfits

Jared can be followed on Twitter at twitter.com/CondorOptions

If you liked this article you might like

Novice Trade: SPY

Novice Trade: SPY

How ETFs Can Boost Your Portfolio

How ETFs Can Boost Your Portfolio

How to Use Options to Your Advantage in This Manic Stock Market

How to Use Options to Your Advantage in This Manic Stock Market

Don't Hate the VIX Game, Hate the 'Tourist' Players

Don't Hate the VIX Game, Hate the 'Tourist' Players

Don't Hate the VIX ETPs, Hate the Tourists

Don't Hate the VIX ETPs, Hate the Tourists