Citigroup’s volatility implosion (zombies aren’t volatile)
April 27th, 2009By David Goldman
The implied volatility of Citigroup options is trading at “only” 150%, against 250% on March 6, the 52-week high for this variable. Citigroup options are pricey (that is, “implied volatility” is high) because owners of Citi preferred can’t find shares of common to short, and options represent the only way to hedge. (I owned some Citi preferreds purchased at a low dollar price, and locked in expected profits on conversion to common stock with a collar consisting of long puts and short calls). The three-month rolling standard deviation of returns to the common remains inordinately high. A GARCH model of the implied volatility, which better mimics where implied volatility should trade, shows a collapse of volatility, however.
Rolling standard dev vs. GARCH is shown in the chart below (left hand axis is in whole numbers, so 1 = 100% implied volatility).
3 Month Rolling Standard Deviation of Returns vs. GARCH Volatility Model (Annualized), March 2008 through April 27, 2009
Three-month rolling standard deviation is at 112% annualized, while 10-day rolling standard deviation is at 180%. But the GARCH model is down to just 55%. It could have (briefly) justified option prices in the 600% implied volatility range, but no more. GARCH (Generalized Auto-Regressive Conditional Heteroskedasticity) measures the degree to which the variable leaps out of bounds set by an auto-regressive estimate. It is designed to mimic the likelihood of big moves outside of bounds.
What the GARCH model tells us is what we perceive intuitively: after the earnings concoction served up by the bank at the end of the first quarter, and after all the contortions of the Treasury, there just isn’t a whole lot left for the market to do. The banks have settled into a zombie existence at low equity prices. They aren’t going bankrupt. They aren’t going to boom. They aren’t going to do much of anything. Zombie is as good as it gets, and zombie is stable. The market is starting to figure this out. Snooze.
April 28th, 2009 at 10:10 am
Ah yes. This is my second month of debit spreads on C and believe me, April was much more profitable. Basically a 2 X 3 debit spread (buy 2’s sell 3’s) yielded 100% (and it hit the max). This month, when C was above 3 (around 3.17) I did the 2 X 3 spread (bought 2’s sold 3’s) and if C closes above 3 at expiration it will only yield about 30%.
Right now the 2 X 3 still looks cheap though. For example, the 2’s are selling at practically zero premium (maybe a penny). The 3’s, which are out of the money as of this morning are over $0.30. The spread would cost under $0.70 (maybe less than $0.65) with the potential of making about $0.35. That’s more than 50% (which is better than where I got in) IF C closes above 3.
Break even would be at about $2.60 - which is better than mine, at $2.75.
April 28th, 2009 at 4:14 pm
Very upset about this — while I sold about 2/3 of my common stock position near the top, I got a little too cute with my limit orders and stop losses and ended up not doing a thing when the market continually gapped lower to open the day.
Now I’m stuck with a position I don’t really want to be in. Mr. Goldman is right that covered calls aren’t exactly paying right now (I’m paraphrasing his post). I am debating whether to hold out for Q2 earnings or just take a bit smaller profit… ? I don’t see another catalyst, but perhaps we can range trade up a bit!
April 28th, 2009 at 6:12 pm
Your comments about Zombie Banks over the last few months have been very clever. I have a feeling that people listening to your advice lately could have made a lot of money taking advantage of the market’s slow learning and odd gyrations. How well have you done lately profiting off of animal spirits, etc.?
April 28th, 2009 at 6:15 pm
You ought to start emailing an investment newsletter to Inner Workings participants.
Buying low and selling high is a good idea, especially when you know what “low” and “high” is relative to the cyclothymic behavior of the market lately.
May 20th, 2009 at 6:26 am
[...] the day was the collapse of VIX to below 30% for the first time since Sept. 15. Falling volatility, I began arguing April 27, was the characteristic trade in an economy in which the Imperial Court set prices, arranged [...]