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SECTOR WATCH: Sizing Up the Select Sector SPDRs
By Frederic Ruffy, Optionetics.com
6/2/2004 10:30:00 AM

http://www.optionetics.com/articles/article_full.asp?idNo=10494

The S&P 500 Index ($SPX) started the year reading 1,111.90. Midday Wednesday, the index was trading at 1,119.01. So, the index has not moved very much during the past five months. In addition, the CBOE Volatility Index ($VIX), which measures the expected volatility of S&P 500 Index options is now near 16.50 and therefore at relatively low levels. So, while the S&P 500 Index has showed relatively little movement so far in 2004, the low readings from the VIX indicate that options traders expect the market to exhibit quiet trading going forward. Yet, this same pattern does not hold across all sectors of the market. Instead, expectations are for volatility to rise throughout most areas of the market going forward. To demonstrate, this article looks at the actual and implied volatility of the nine S&P 500 Select Sector SPDRs.

Select Sector SPDRs are a group of exchange-traded funds [ETFs] that hold baskets of stocks from various economic sectors. Collectively, the Select Sector SPDRS hold the five hundred stocks included in the S&P 500 index. Shares of these nine funds trade on the American Stock Exchange [AMEX] and can be bought and sold like stocks. Options are also listed on these investment vehicles.

Table 1 lists the nine Select Sector SPDRs, the ticker symbol, and the performance of each fund so far this year. Energy has been the best performing sector and the Select SPDR Energy Fund (XLE) is up 9.5%. Consumer stables, healthcare, and financials have also performed relatively well. Technology and basic material stocks have lagged the market. The mixed performance of the various sectors of the market helps explain the lack of movement in the S&P 500 Index. In short, gains in some sectors have offset losses in others.

Select Sector SPDR
Symbol
Performance Since December 31, 2003
20-day Statistical Volatility
Implied Volatility

Energy
XLE
9.47%
21.50%
20.50%

Consumer Staples
XLP
5.83%
9.10%
12.70%

Health Care
XLV
2.55%
9.70%
15.10%

Financials
XLF
1.28%
13.50%
18.80%

Industrials
XLI
1.08%
13.00%
15.00%

Utilities
XLU
0.86%
17.20%
17.30%

Consumer Discretionary
XLY
0.22%
17.40%
17.00%

Information Technology
XLK
-1.82%
12.80%
18.80%

Basic Materials
XLB
-4.23%
20.40%
21.20%


The table also shows the volatility of the various funds using the 20-day Statistical Volatility [SV] and Implied Volatility [IV]. SV is measure of volatility that is computed as the annualized standard deviation of closing prices during the past twenty days. Put simply, the higher the 20-day SV, the greater the volatility of the instrument during the past twenty days. Notice that the market’s top performer has also been the most volatile. The worst performer, basic materials, has also been the second most volatile. Therefore, as one might expect, the more volatile sectors have experienced the largest percentage moves.

While SV is computed using past prices, implied volatility is a measure of the expected volatility of the underlying asset. It is a derived from the option premiums using a model. When IV is high, it is a sign that traders expect the volatility of the underlying asset to exhibit high volatility. When it is low, the option premiums are pricing in expectations of low volatility. For instance, the IV of the Select Sector SPDRs Energy Fund and the Select Sector SPDRs Basic Materials Fund (XLB) are the highest today. Therefore, traders expect energy and basic material stocks to exhibit the greatest volatility going forward. Indeed, this probably owes to the fact that, as we have seen, these two groups have exhibited the greatest amount of volatility in the past.

Contrary to one might expect, information technology stocks have been among the least volatile. Historically, technology stocks have tended to experience larger percentage moves than most other sectors of the market. Yet, the Select Sector SPDRs Technology Fund (XLK) has statistical volatility of less than 13%, which, compared to other funds, is low. However, looking at the IV of the technology fund suggests that traders do not expect this period of low volatility to last. The implied volatility of the XLK is almost 19%. Similarly, financial stocks, which currently account for the largest percentage of the S&P 500 Index, have exhibited relatively low volatility, but now have IV near 19%.

So, judging by the implied volatility of the Select Sector SPDRS, traders expect that this period of relatively quiet trading during the first five months of 2004 will give rise to greater volatility going forward. In addition to technology, financials, energy, and basic materials funds, the implied volatility of healthcare, utilities, and consumer staples remains relatively high when compared to the past. So, if expectations are correct, and many of these sectors do begin to exhibit greater volatility, the S&P 500 Index may begin to make larger percentage moves and the VIX will begin to tick higher.


Frederic Ruffy
Senior Writer & Index Strategist
Optionetics.com ~ Your Options Education Site
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