Up In Flames?

Just an observation, but The Stable of Punditry does not grasp the concept of Black Swans. As per Nassim Taleb, “a black swan is a large-impact, hard-to-predict, and rare event beyond the realm of normal expectations.”

I heard some guy on TV earlier describing black swans out there in LIBOR and inflation. By definition, if he is identifying them, and they are far from radical observations (Abnormal Returns coincidentally has links to 3 LIBOR related posts today alone), then they are not Black Swans.

Big spike up in OTM cheapie put buying in CSX, BNI and NSC last week ahead of CSX earnings. Precisely the sort of smart money we have heard so much about lately.

And lo and behold, CSX reports, and today the stock hits 52 week highs.

I can’t emphasize enough not to get carried away with following *smart money* into shorts based on someone else purchasing cheap puts.

CXO has a study here with this conclusion, “…evidence supports beliefs that informed traders distort the relationship between the prices for put and call options on individual stocks and that others may be able to exploit these distortions. Relatively expensive calls (puts) predict stock outperformance (underperformance)”.

That works up to a point. but let’s go back to the black swan thought. If the masses are identifying a Black Swan in our midst before it even appears, it is not a black swan any more. After a few high profile blowups, the Search for the Next Black Swan Trade got a bit crowded.

So with earnings season and a generally ugly market as the backdrop, the VIX never ceases to dissappoint. But how about individual stock volatility?

Not so bad.

Don Fishback takes an interesting look.

What if traders stopped buying puts on broad-based indexes (which research has shown is a losing strategy) and instead bought puts on individual stocks? For instance, what if they bought puts on Citigroup, Exxon, GE and GM instead of puts on the S&P 500? It’s sort of like the dispersion trade and dynamic hedging all rolled into one. [The dispersion trade is designed to take advantage of the difference in the volatility of the individual securities in an index relative to the volatility of the index itself.]

Here’s where our extensive database comes into play. We’ve been keeping a record of the closing bid/ask of every stock, index and ETF ever traded since 1999. We can use that data to calculate the implied volatility of each and every one of those stocks for every day. We can then create an index that measures the aggregate implied volatility of individual securities in a stock index. We did that for the S&P 500. For simplicity’s sake, I am going to call our index SPXIV. It is the equal-weighted implied volatility of the individual constituent securities in the S&P 500. We can then compare that volatility to the implied volatility of the index options as measured by VIX.

If people are buying options on individual securities instead of buying options on the index itself, we should see the gap between SPXIV and VIX rise, as the implied volatility of the individual options rises faster than VIX.

Don runs a couple graphs, and indeed we do see relative outperformance by individual stock volatility.

So what does that tell us?

Two things. One is that Don is right in that over the course of time, many have found index option buying to be an exercise in frustration. And many presumably switched to simply buying individual stock options. Even at option pricing troughs of 2006, index volatility still didn’t pan out. The volatility of the underlying indices themselves remained consistently lower than the option volatility.

The other though is that there is a second factor in comparing individual stock volatility to index volatility, and that is correlation. If correlation is high, i.e. all stocks are rising or falling in unison, then the disparity between a number like Don’s SPXIV and the VIX will be relatively low.

Don’s numbers imply we are in a low correlation environment, wherein we have different sectors moving different ways. And it’s important to remember that this can last a while. But at the same time, it’s somewhat cyclical. So don’t be shocked if somewhere down the pike (probably the next market meltage) you see a blast in index volatility relative to individual stock volatility.

Seems like a theme lately, but Rebecca Darst of Interactive Brokers was on earlier getting the Mark-Erin 3rd degree on what options were telling her about earnings expectations.

The big name she had was CAT, which reports Friday, and she notes the board is anticipating about a 5 % move. Mark and Erin want to know what the smart money is doing, and she points out there was a put explosion since GE Friday.

Now here would be my point again from the last couple days. You really want to be careful calling this “smart” money. And she’s not, the hosts are. GE lays an egg, the market gets nervous that it’s not just financial that will take earnings hits and everyone wants puts in CAT and HON and I imagine Whirlpool and a host of others too. Clearly there is money flow into puts, but is that really smart money, with the implication that you want to follow it?

Earnings reports do not occur in vacuums. Let’s say early on, like this season, option bidups are pretty light. And then we get some bad reactions and options sellers get burned. What do they do? They start bidding higher, and buying puts, for the next batch of reports. If anything, that becomes a fade.

It’s Expiration Week, option volume and open interest is relatively high, actual stock volume is mediocre. And we have seen declining volatility this month. Not to mention a range bound market where option shorts have *hand* Sounds like a recipe to see some pinning action this week.

Now it’s only Tuesday, so I would strongly advise against getting carried away with this. A broader market or sector move will blow away any push or pull towards a strike.

But if you’re of a mind to start looking for some pin candidates, WJB Capital Group runs a list of leading candidates based on combined put/call open interest and relates it to average daily volume.

Some interesting candidates that caught my eye are TGT at 52.5 (combined open interest of 62,800), QCOM at 42.5 (109,000 calls open) and DIS at 30 (72,000 open interest, though 60,000 of them are puts). SHLD has a very high open interest to average daily volume ratio on the 100 line, but that one strikes me as a bet you really want to wait on until later in the week as it could be a strike or two away from here.

How would you play for a pin? Buy some DEEEEEEEP Calls of course with 6 month’s to go.

OK, just kidding, you would look to sell options on the line you are targetting. Do it early in the week and you obviously get more premium, but you risk any sort of move that swamps the relatively minor effects here. And I would note that WJB is likely not screening their list for earnings or company meetings or whatever, and I am not either.

“Now, there are probably four or five people in the world who, if they sent me an e-mail, told me to learn a stock, I would actually take them seriously… [Lenny]’s one of the great ones in this business. He’s one of the great ones.”

Jim Cramer

The average daily return for the stocks Lenny Dykstra picks matches that of the broad stock market almost exactly, suggesting no stock picking ability.

CXO Advisory

So who’s right here? CXO Advisory runs all sorts of number-crunchie-thingees on Lenny’s sage investing strategy, so let’s dig in. Hat tip Abnormal Returns.

OK, first hat tip Abnormal Returns, many thanks to everyone who sent this over.

As a first test, we construct and calculate the daily returns for a portfolio consisting of all the stocks underlying options positions recommended by Lenny Dykstra during 2/7/07-11/8/07 (121 separate recommendations encompassing 85 distinct stocks). We use daily closing prices adjusted for splits but not dividends to track prices that an options buyer experienced during subsequent holding periods. We keep each stock in the portfolio for four months to match the expiration-date approach of his options strategy. The portfolio ranges from one stock (at the very beginning and very end) to a high of 64 stocks. Average daily portfolio size is 38 stocks. Also in rough accordance with his options strategy, we calculate portfolio returns on an equally-weighted basis. Results are:

• The average daily return of the equally-weighted stock portfolio is 0.00% with standard deviation 1.02%.
• The average daily return for the value-weighted S&P 500 index over the same period is 0.00% with standard deviation 1.01%.

Zero point Zero. Yes, Lenny will heretofore be known as Lenny Simpson Day Dykstra. Important to note how many positions he holds on average and at max.

As a second test, we investigate how the performance of the underlying stocks suits the options strategy based on time variation. Rapid price appreciation would maximize return on investment with quick, successful trades and mitigate erosion of the relatively small time value of deep-in-the-money call options. For this test, we align the buy dates for all sample positions and construct an equally-weighted profile of the returns over a four-month period (about 84 trading days). For comparison, we construct a similar profile for the S&P 500 index by “buying” a four-month position in the index each time Lenny Dykstra recommends a new stock and aligning the start dates of all these index positions. The following chart presents the profiles, with description as follows:

• On average, Lenny Dykstra’s positions tend first to dip over two weeks and then recover and appreciate over the next six weeks before stabilizing for the balance of the four-month holding period.
• Comparable activity in the S&P 500 index on average beats Lenny Dykstra’s recommended stocks initially but falls behind after about two months.

Results suggest that Lenny Dykstra may be able to identify small intermediate-term undervaluations, but he tends to enter positions too quickly. He thereby on average “wastes” option time value during the month after the buy date.

It’s actually interesting that over the course of time, his picks work out relatively well. His stock picking can be summarized as “famous stocks that got slammed”. That’s very tough to time on the buy side, which is why his DEEEP Call quick flip plan makes literally no sense. I would think scaling in and holding with some sort of discipline to stop out real clunkers is a better idea.

As a third test, we examine the the assumptions in the return on investment calculations offered on 11/9/07 by Lenny Dykstra. These calculations have some shortcomings, as follows:

• Some of the calculations are for closed positions only, essentially assuming that open positions will perform similarly to closed positions. However, the strategy tends to carry a bow wave of unsuccessful positions that grows with market downdrafts. Given the behavior of the broad stock market in the four months after 11/9/07, the untracked open positions as of that date have probably degraded overall return on investment substantially.
  
• The calculations inconsistently address the cash position that a trader would have to maintain to assure the ability to implement new recommendations, including those for averaging down after short-term setbacks. A complete trading strategy would specify a closed system, defining the necessary cash position and including the return on cash in the overall return on investment.
  
• More generally, the strategy is sensitive to broad market conditions (trend and volatility). It would likely “crash” during a substantial market decline persisting for several months, with the crash magnified by a policy of averaging down rather than exiting after setbacks. As noted, the positions open as of 11/9/07 could well have crashed the overall return for recommendations made during 2/7/07-11/8/07.

The following chart (click thru to see) amplifies points 1 and 3, showing the average cumulative performance of the stocks underlying Lenny Dykstra’s options positions that were open as of 11/9/07. The almost monotonic decline of of the stocks suggests that many of the initial call option positions, and any subsequent buys to average down, may well have ended as total losses. Failure to follow up by incorporating the results of these positions in the overall return on investment calculations is deceptive.

Yes, yes and yes. These are identical observations to those made over and over again on these pages. Except this time well-written and with numbers.

Is this study perfect? No. I’ve been emailing up and back with a reader, who in turn emailed up and back with CXO. What is missing is any analysis of whether the actual use of the DEEEEEPS (which I would suggest are thrown in there for some sort of marketing angle, and truly make no sense the way he uses them).

But it parses Lenny pretty well imho, and is a refreshing change to the “regular” media, which generally just takes all Lenny and Jimmy’s claims of Success Rates and Big Returns at face value.

So, remember last week when CNBC had a couple Options Folk on TV discussing what options were telling us about earnings? They discussed magnitudes, not directions.

That is actually the best info options can tell us pre-earnings. But it’s bad TV; better to guess direction. And that’s what we had today with Randy Frederick and Pete Najerian

Now “guess” is not a fair word on my part. They are basing their opinions on put volume. Spefically, they were bearish on WB based on the excess put trading Friday, and are still bearish on this week’s financials (Citi and Merill) based on similar trading.

But I just want to highlight something. It’s not so simple. You can’t just look for heavy put volume and assume all that money is smart and just go short everything with that pattern. Put volume in a news vacuum; that can be a directional tell of smart money. Put volume ahead of a known news event though? Just as likely it connotes excess nervousness, or, importantly pre-discounting of bad news. Citi may very well be a disaster, but couldn’t these puts also be telling us that it is discounted in the stock to some extent?

Adding that the WB is a bit confusing. There was in fact news expected (earnings) but you also had widening CDS spreads.

Dr. J is on now answering this very question and highlighting that it was the big blocks of puts in WB that set off the alarms. And he notes that Honeywell (HON), due to report Friday, shows a similar pattern.

But here’s a perfect example where caution is advised. HON is seeing put interest based on GE’s miss. And earnings may indeed suck, but you have to question to what extent a bad whisper is priced into HON, and whether this put interest actually proves bullish by Friday.