Russell’s Redux – Follow Up to this Weekend’s Review

On Monday I referred to a recommendation that appeared in the Striking Price column in Barron’s regarding the energy sector. I found this particular recommendation interesting, not due to the outlook on energy, but a reference to Select Sector Energy SPRD (XLE). Specifically, that Chevron (CVX) and ExxonMobil (XOM) represent about 1/3 of the XLE capitalization. With this heavy weighting of the XLE represented by two stocks comparing strategies with XLE, CVX, and XOM options popped in my mind.

The recommendation involved buying Select Sector Energy SPDR (XLE) put options. This idea is a way to benefit from weakness in the sector that may accompany the end of QE2. The feeling is with the quantitative easing, there has been an abundant of long commodity trades that now would be unwound. Lower oil prices and lower energy stock prices would be a result.

Last Friday the XLE closed at 70.93. As of mid morning today (Wednesday the 29th) the XLE is trading at 74.28 or up about 4%. I often like to revisit ideas from Barron’s midweek after the issue has come out. When the stock has moved in the opposite direction of the recommendation, I like to spend some more time investigating the idea.

In the column buying puts that expire 3 to 6 months out was suggested.  I’m focused on the August and January 2012 expirations as XLE, CVX, and XOM all have option series that expire in these months. The trading idea also suggested looking at contracts that are 5% below the current market. With the XLE currently at 74.28 a 5% drop would take the ETF down to 70.57, rounding down I’m looking at the 70 Puts. Mid morning Wednesday the XLE Aug 70 Put was at 1.19 and the XLE Jan 2012 70 Put was at 4.00. XOM is trading at 80.19 so the closest strike to a 5% loss is 75. CVX is trading at 100.97 and the result is the 95 strike contracts. The XOM Aug 75 Put could be bought at 0.96 and the XOM Jan 2012 75 Put is going for 3.60. A CVX Aug 95 Put is offered at 1.52 and the Jan 2012 95 Put is trading at 5.35. A summary of all six put contracts appears in the table below –

 

August Expiration

Premium

Implied VOL

XLE Aug 70 Put

1.19

26.32

CVX Aug 95 Put

1.52

24.09

XOM Aug 75 Put

0.96

23.21

 

January Expiration

Premium

Implied VOL

XLE Jan 70 Put

4.00

26.82

CVX Jan 95 Put

5.35

25.50

XOM Jan 75 Put

3.60

23.90

 

I have added the implied volatility of these options to the table. What is interesting to me is the lower volatility of the individual stock options versus the implied volatility of the XLE. When I read the article, my automatic assumption was the more diversified XLE would have a lower implied volatility than that of the individual stock options. However, now using implied volatility as a relative measure of ‘expensive’ or ‘cheap’, the XOM contracts appear to offer the best deal. I took this one more step and the outcome is displayed the following table –

 

August Expiration

Premium

Implied VOL

2011 Volatility

XLE Aug 70 Put

1.19

26.32

21.10

CVX Aug 95 Put

1.52

24.09

18.36

XOM Aug 75 Put

0.96

23.21

19.10

 

January Expiration

Premium

Implied VOL

2011 Volatility

XLE Jan 70 Put

4.00

26.82

21.10

CVX Jan 95 Put

5.35

25.50

18.36

XOM Jan 75 Put

3.60

23.90

19.10

 

Using Microsoft Excel, I did a quick calculation of the annualized volatility of XLE, CVX, and XOM. Historical volatility should never automatically be assumed an indication of price movement. I do think comparing historical and current implied volatility is useful in this case. Using 2011 closing prices, XLE has been a more volatility trading vehicle and therefore may justify the higher implied volatility relative to CVX and XOM. Finally, note that relative to trading this year, the implied volatility of CVX options may be considered more expensive than the XLE contracts.

The usual expectation is that exchange traded fund option contracts should have a lower implied volatility than that of the components of the exchange traded fund. This may not hold true for a sector exchange traded fund, where the stocks that comprise the ETF are highly correlated. It is possible that some components may price in lower forward looking volatility than the ETF and that this pricing may be justified.