Volatility Resurfaces

Terry Flanagan

The recent surge in bond yields, after a long dormancy, roiled equity markets and underscored that traders need to remain vigilant even in seemingly placid markets.

Yield on the U.S. 10-year Treasury note increased by more than a full percentage point in less than eight weeks, to as high as 2.66% on June 24 before leveling off. The equity benchmark Standard & Poor’s 500 Index declined and then rose during that period, as measures of volatility tracked higher.

“We have at least had a glimpse of how quickly the landscape can change,” said Randy Frederick, managing director of active trading and derivatives at the Charles Schwab Center for Financial Research. “This should be a warning sign for short-term traders to stay nimble.”

In a research note, Frederick said market-wide volatility is likely to be flat this week, as monthly options expire. Price fluctuations are expected in individual companies, especially those that announce second-quarter earnings.

After weeks of exogenous factors moving equity and derivative markets, “a return to fundamentals is something all investors should welcome with open arms” Frederick said.

“While most of the economic reports last week were on the moderately negative side, they could not dampen the renewed bullishness in the equity markets brought about primarily by statements from members of the Fed, and confirmed last Thursday by Chairman Bernanke, that the Fed would remain highly accommodative for the foreseeable future as unemployment and inflation targets remain elusive,” Frederick said.

After declining almost 6% in a couple weeks, investor focus turned to the good news in the July 5 employment report, rather than the implied and perceived bad news, which is that strong economic numbers mean rising rates are on the way.

“It seems that good news is finally good news again,” Frederick said. “Now that the correction has passed, traders could not be blamed for thinking the previously hawkish comments which sparked the correction in the first place, were a cleverly disguised ‘test’ to gauge market reaction. I think we now know that it doesn’t take much to spook equity investors, and even less to spook the bond market.

Frederick said investors with a time horizon at least through year-end should be in good shape, and the next few months may be favorable for shorter-term options-market participants.

According to Frederick, “with the strength of the recovery last week pushing the market to record levels once again, substantial additional near-term gains could prove to be relatively limited in the near-term, but that could make Q3 an ideal environment for those investors frustrated by the underperformance of option income strategies (i.e. covered calls, CSEPs) in the first half of the year.”

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