Howard Simons BP Option Skews and Its Risk of Ruin
BP Option Skews and Its Risk of Ruin
By Howard Simons Jun 16, 2010 7:45 am
When will the oil company be out of the woods?
You always hear "When you're a hammer, the whole world looks like a nail," which begs the question: What does the world look like to a screwdriver? But we do know what the world looks like to equity option traders with volatility smiles and skews; at normal times and during normal circumstances, we expect volatility at lower strikes (“moneyness” less than 100%) to be higher than that of higher strikes (moneyness greater than 100%). This occurs with regularity both at the single-name levels and at the index level, where measures such as the VIX rise when the S&P 500 falls, and vice-versa.
We also expect volatility to have a smile, or pattern of higher volatility, as we move away from the at-the-money, or 100% moneyness, strike. Armed with these expectations, we can make certain inferences whether options are pricing in a greater risk of a firm disappearing from the scene. If this is the case, we should expect to see greater-than-normal volatility at the 100%+ moneyness strikes as put option buyers become willing to forgo the greater leverage of the out-of-the-money strikes in return for a rising probability of the options with greater intrinsic value expiring at their maximum of [present value of strike less premium paid].
As an aside, this is one of the major differences between stocks and commodities and why you shouldn't treat them as one and the same. Try though as you may, you can't force corn or copper into bankruptcy. Stocks can, and do, start singing in Monty Python’s choir eternal.
And in a second aside, which uses up my allotted maximum for one week, the credit default swaps of a firm in trouble not only rise with its equity volatility in these cases, but the forward curve of CDS costs inverts; short-dated CDS cost more than their longer-dated counterparts. In the case of BP (BP), these CDS are priced in euros, which means the successful buyer of CDS protection on BP would get paid in euros; you're free to sort out the implications of this absurdity for yourself.
BP History
If we map BP volatility at a succession of dates including the April 20, 2010 explosion of the Deepwater Horizon rig and three gap-down days thereafter, we see the rising volatility skewed toward the sub-100% strikes we expect.
If we now rearrange the very same data to a smile map where each strike’s volatility is taken as a ratio of the 100% moneyness strike, we see a second pattern. The relative volatility of the 105% and 110% moneyness strikes starts to increase; by the time we get to the June 1 and June 9 gap-down days, these volatilities have increased well beyond their starting values (highlighted in violet data points).
The market is pricing in the risk of ruin here just as it has for firms such as Transocean (RIG) and, earlier in the year, for Goldman Sachs (GS). The financial crisis of 2008 produced a series of such events, including astonishingly high volatility readings for firms such as Morgan Stanley (MS) and Citigroup (C) still with us.
BP will be out of the woods according to option traders when the 100%+ moneyness levels decline to normal in relation to also-declining ATM volatility levels. That is one way of looking at it. The other way is it will be out of the woods when the US and British governments decide who pays what to whom and what will be left over as a functioning corporate entity. What does the world look like when you're a politician?
It is always fun to sit around the digital campfire and speculate about Really Big Events. Not only does it beat working for a living, it makes you feel more important than you really are and, like a double-shot of espresso helps you fritter and waste the hours in an offhand way. What events have been bigger than the Second Hellenic Boo-Boo and its corollary concern, which is why do we have the euro in the first place?
The answer to the second question is surprisingly straightforward: We have the euro because the European elites really wanted to feel they were in control of something greater than a group of smaller countries who had a bad tendency to clobber each other with distressing frequency. The answer to the first question is the events in Greece, certain to end with a default that will not be called a default and a bailout that will not be called a bailout, never constituted an existential threat to the euro.
Let’s illustrate this with a technique borrowed from a risk-of-ruin analysis for BP (BP) back in 2010 (see BP Option Skews and Its Risk of Ruin) when the Macondo well was still making an unholy mess in the Gulf of Mexico. If we map the volatility skew and smile for options on the euro at various large up- and down-days so far in 2011, we will not see a rise in at-the-money volatility relative to out-of-the-money volatility for put options. The large rises in the euro will have a green theme and the large declines a red theme.
First, let’s take a look at the implied volatility of euro options by moneyness. We see a definite skew toward higher volatility at lower prices, an investor skew phenomenon similar to stock option volatility. In the absence of the color-coding, would you be able to tell me which were the up and down days? Not really; the pattern on May 27, 2011 when the euro rose is about the same as it was on May 5 and June 15 when the euro fell. This should be our first clue that the options market is not pricing in the euro’s disappearance.
Now let’s normalize everything to the ATM volatility level. If the options market associated a large downward move in the euro with a risk of ruin, you would see the 100%+ moneyness strikes’ volatility ratio to the ATM volatility rise. Such a move would not be seen as the lottery-ticket often associated with buying out-of-the-money options but rather a more binary bet on the euro disappearing.
One of the ironies is currencies can and do disappear. For example, the Brazilian real (BRL) came into existence in 1994 after the country had gone through the cruzeiro, cruzerio novo, cruzado and cruzado novo. Germany was proud of its Deutsche mark, but maybe it does not like to talk about its predecessors in the 20th century. If you travel in Mexico, you see the symbol “N$” for the peso; that is to distinguish it from the old peso of blessed memory.
The euro may one day bite the dust unless they find a way to allow countries to exit the arrangement. Right now, no such mechanism exists and the eurozone’s leadership will move heaven and earth to preserve their project. The options market likes their chances for success
We also expect volatility to have a smile, or pattern of higher volatility, as we move away from the at-the-money, or 100% moneyness, strike. Armed with these expectations, we can make certain inferences whether options are pricing in a greater risk of a firm disappearing from the scene. If this is the case, we should expect to see greater-than-normal volatility at the 100%+ moneyness strikes as put option buyers become willing to forgo the greater leverage of the out-of-the-money strikes in return for a rising probability of the options with greater intrinsic value expiring at their maximum of [present value of strike less premium paid].
As an aside, this is one of the major differences between stocks and commodities and why you shouldn't treat them as one and the same. Try though as you may, you can't force corn or copper into bankruptcy. Stocks can, and do, start singing in Monty Python’s choir eternal.
And in a second aside, which uses up my allotted maximum for one week, the credit default swaps of a firm in trouble not only rise with its equity volatility in these cases, but the forward curve of CDS costs inverts; short-dated CDS cost more than their longer-dated counterparts. In the case of BP (BP), these CDS are priced in euros, which means the successful buyer of CDS protection on BP would get paid in euros; you're free to sort out the implications of this absurdity for yourself.
BP History
If we map BP volatility at a succession of dates including the April 20, 2010 explosion of the Deepwater Horizon rig and three gap-down days thereafter, we see the rising volatility skewed toward the sub-100% strikes we expect.
If we now rearrange the very same data to a smile map where each strike’s volatility is taken as a ratio of the 100% moneyness strike, we see a second pattern. The relative volatility of the 105% and 110% moneyness strikes starts to increase; by the time we get to the June 1 and June 9 gap-down days, these volatilities have increased well beyond their starting values (highlighted in violet data points).
The market is pricing in the risk of ruin here just as it has for firms such as Transocean (RIG) and, earlier in the year, for Goldman Sachs (GS). The financial crisis of 2008 produced a series of such events, including astonishingly high volatility readings for firms such as Morgan Stanley (MS) and Citigroup (C) still with us.
BP will be out of the woods according to option traders when the 100%+ moneyness levels decline to normal in relation to also-declining ATM volatility levels. That is one way of looking at it. The other way is it will be out of the woods when the US and British governments decide who pays what to whom and what will be left over as a functioning corporate entity. What does the world look like when you're a politician?
It is always fun to sit around the digital campfire and speculate about Really Big Events. Not only does it beat working for a living, it makes you feel more important than you really are and, like a double-shot of espresso helps you fritter and waste the hours in an offhand way. What events have been bigger than the Second Hellenic Boo-Boo and its corollary concern, which is why do we have the euro in the first place?
The answer to the second question is surprisingly straightforward: We have the euro because the European elites really wanted to feel they were in control of something greater than a group of smaller countries who had a bad tendency to clobber each other with distressing frequency. The answer to the first question is the events in Greece, certain to end with a default that will not be called a default and a bailout that will not be called a bailout, never constituted an existential threat to the euro.
Let’s illustrate this with a technique borrowed from a risk-of-ruin analysis for BP (BP) back in 2010 (see BP Option Skews and Its Risk of Ruin) when the Macondo well was still making an unholy mess in the Gulf of Mexico. If we map the volatility skew and smile for options on the euro at various large up- and down-days so far in 2011, we will not see a rise in at-the-money volatility relative to out-of-the-money volatility for put options. The large rises in the euro will have a green theme and the large declines a red theme.
First, let’s take a look at the implied volatility of euro options by moneyness. We see a definite skew toward higher volatility at lower prices, an investor skew phenomenon similar to stock option volatility. In the absence of the color-coding, would you be able to tell me which were the up and down days? Not really; the pattern on May 27, 2011 when the euro rose is about the same as it was on May 5 and June 15 when the euro fell. This should be our first clue that the options market is not pricing in the euro’s disappearance.
Now let’s normalize everything to the ATM volatility level. If the options market associated a large downward move in the euro with a risk of ruin, you would see the 100%+ moneyness strikes’ volatility ratio to the ATM volatility rise. Such a move would not be seen as the lottery-ticket often associated with buying out-of-the-money options but rather a more binary bet on the euro disappearing.
One of the ironies is currencies can and do disappear. For example, the Brazilian real (BRL) came into existence in 1994 after the country had gone through the cruzeiro, cruzerio novo, cruzado and cruzado novo. Germany was proud of its Deutsche mark, but maybe it does not like to talk about its predecessors in the 20th century. If you travel in Mexico, you see the symbol “N$” for the peso; that is to distinguish it from the old peso of blessed memory.
The euro may one day bite the dust unless they find a way to allow countries to exit the arrangement. Right now, no such mechanism exists and the eurozone’s leadership will move heaven and earth to preserve their project. The options market likes their chances for success
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