Saturday, 14 April 2012

Natural Gas Implied Volatility: Drift Back To Normalcy

Event-specific circumstances, sometimes, create interesting situations for deploying capital. The Indian Natural Gas sector presented one such instance; in Equities and Implied Volatility, this week. 

Background note here

IVs popped across the board, principally manifesting in Indraprastha Gas (Bloomberg: IGL IN, NSE: IGL), which was the chief victim in the melee. Reacting to the adverse regulatory pronouncement, other companies in the Natural Gas space too came under fire from investors, IVs spiked as stock prices swooned. IGL stock fell over 40% within minutes and other companies shed double digit percent. Petronet LNG (Bloomberg: PLNG IN, NSE: PETRONET), however, should have escaped relatively unscathed, as the ruling is expected to have little impact on its earnings power. But fear is a pervasive force, which divorces with rationality in time of duress. Time eventually acts as an arbiter in the estrangement but the process is gradual and fraught with roadblocks.

Panic-induced selling traces a typical cycle. An event acts as a stimulus, triggering ripple reactions (and over-reactions) in several directions. The magnitude and length of time of the selling is contingent on the gravity and expected persistence of the negative information. Once the initial wave of selling abates, traces of value can often be found in several pockets.    

The PNGRB ruling was directed towards gas transportation and compression operations. Regasified LNG, PETRONET's core business, did not fall under the purview of the regulator. To this extent, PETRONET's earnings power was insulated against the adverse regulatory development. The stock, however, shed about 12% minutes after the stimulus triggered widespread selling. The magnitude of correction was overdone, taking PETRONET's valuation to levels (sub-10x P/E, 5-year historical P/E = 14x), which offered an attractive value proposition for long-term oriented investors. PETRONET's per share earnings have grown at over 30% annually over 2006-Dec 2011. Turning to India's natural gas fundamentals, the favourable demand-supply gap is unlikely to reverse in the near future. The natural gas deficit situation is likely to persist over the medium-term and PETRONET is likely to realise above-average prospective growth in per share earnings. As market participants absorbed the impact of the regulatory development, Longs moved in to PETRONET and the stock recovered most of its losses by the close of the day. 

IVs had been hovering in the early 30s in late-march/early-April. The event stimulus resulted in PETRONET IVs popping across the board, with strong skew emergence as participants scrambled to buy downside protection. IVs increased to rich levels relative to history and Short Volatility postures offered attractive risk-reward.

The following chart captures the evolution of Implied Volatility and PETRONET Put Option Greeks, across strikes, in the few days post-event.

As normalcy returns gradually, IV and Vega (sensitivity of Option prices to changes in Volatility) are gradually drifting lower. For an option insurer, shorting Volatility at higher-than-normal levels improves risk-reward materially, offering a reasonable margin-of-safety. Subsequent IV compression leads to value realisation. The compression is most prominent in close-to-money strikes, with deep OTM strikes exhibiting lower sensitivity but working wonderfully, nonetheless.

Classic value emergence across the equity piece in the capital structure and in volatility, a less-widely viewed asset class. 

Disclosure: Expressed & unwound profitable Short Volatility positions. Continue to hold certain positions, as of this writing. 

Disclaimer: This is not a solicitation to buy/sell any instrument discussed here. Views are contingent on future circumstances and may change without notice. There is immense risk of loss in Options investing. Please consult your adviser, and more importantly your judgement, before making investment decisions.  

Tuesday, 10 April 2012

Ruckus, Volatility Skews & Gap Risk

It has been quite an eventful day for the Indian Natural Gas pack, which are quite effervescent as I write. 

The ruckus was triggered by a ruling by the Petroleum and Natural Gas Regulatory Board (PNGRB), fixing new tariffs for natural gas players. The PNGRB lowered gas network tariffs and compression charges by over 60% each. This prompted a free fall in stock prices of Natural Gas companies, with Indraprastha Gas (Bloomberg: IGL IN, NSE: IGL) caving in 40% within minutes of market open, on the back of rampant selling, as sell-side analysts rapidly scaled down forecasts. Other stocks shed between 5-15%.

A ruckus is generally kind to Volatility. Natural Gas Implied Volatility, which was quite tepid since mid-March '12, spiked reacting to the adverse newsflow. IV skews, which were flattish around the long weekend (April 4, 2012), have now turned into smirks as Puts have come into focus. The scramble for buying protection has pushed up Put prices. Spiking IVs offer attractive possibilities to deploying capital. Petronet LNG (Bloomberg: PLNG IN, NSE: PETRONET) & GAIL (Bloomberg: GAIL IN, NSE: GAIL) IV skews paint an insightful picture. 

Though IVs have picked up across the board, OTM Put IVs particularly, have bumped up neatly and now offer a reasonable risk-reward.  

Queerly, skew was inverted going into the long weekend. Generally, lower liquidity in OTM strikes should impel Option Writers to demand higher compensation for assuming Gap Risk. Writers, however, seemed happy to assume risk for low, flattish skews.

A long weekend brings its own advantages and disadvantages. The advantages gained through a Long Theta posture needs to be weighed against the possibility of Gap Risk, after the long weekend. As market participants process and assimilate developments materialising over the weekend, the chances of a Gap Open (up or down) becomes likely. One way of somewhat mitigating this risk while enjoying the benefits of time decay is to demand higher IVs. The other is to own cheap protection at low IV.

The Natural Gas pack is hounding the Longs today. The next few days will be interesting indeed.

Sunday, 8 April 2012

A Resurrection In Sentiment?

The Day of Resurrection is probably an opportune moment to pause and gauge the pulse of the market.

After the forgettable dalliance with 2011, risk assets seem to have found an amenable ally in 2012 so far. Tepid interest from FII towards India in 2011 has been replaced by renewed fervour ($9 billion net inflows in 1Q2012 v/s -c.$1 billion net outflow in 2011). 

Interestingly, very little has changed fundamentally. The March budget was a damn squib, with the Finance Minister hoping to walk the tight rope between taming inflation, curbing a burgeoning fiscal deficit, without fettering growth. The Budget was, however, low on major reforms and irksome issues continue to make their presence felt. Yet, FII continue to pile in. 

One of the intriguing things about human behaviour is its stickiness in altering the status quo prevailing bias. After a prolonged period of bull market, bearishness/pessimism is a rarity; likewise, after a bearish period, bullishness/optimism is a rarity. Bull markets are fuelled by optimism, which is confidence's child. The circular relationship seems to portend that confidence is a necessary prerequisite to bull markets. This needn't always be the case. 

When much bearishness is already imputed in prices, a minor dose of optimism is enough to take prices higher (converse is true around market tops). In temporal terms, optimism is a short-term phenomena, while confidence is more structural. Tangible on-the-ground improvement in business environment is a necessary catalyst to support sustained confidence.

Quick glimpse of the thermometers that I keep an eye on to gauge sentiment.

Is the bull market here? Or, is this a temporary oasis of optimism? 

Commodities, except Crude Oil, had a stellar January '12, as the risk-on trade gained backers on the possibility of QE3 favouring risk assets. February was quieter and March proved to be speed-breaker to budding optimism. 

The price performance of Healthy v/s Weak companies is a useful indicator of market participant focus of interest. 'Healthy' contains debt-free/net cash balance sheet companies, 'Weak' contains the most indebted ones. 

After a spell of negative price performance, a spell of optimism generally favours the indebted over the conservative. The debt-heavy tend to fall so greatly in a bearish environment that a temporary reversal in sentiment is enough to propel these pockets higher, as participants cycle out of defensives. As always, sustenance is key to gauge a structural shift.

January '12 was very favourable to the Weak companies in my index but follow through has been stolid. February saw the Healthy beating the Weak and March turned out to be inglorious for both, more so for the Weak. One of the companies in my Weak pack is Kingfisher Airlines (Bloomberg: KAIR IN, NSE: KFA), which is sparring with possible bankruptcy.

Gauging behaviour is one of the most challenging aspects in investing. Numbers convey a picture and they have their utility as communicators of market sentiment. But they cannot conquer uncertainty. Just as a good doctor, with experience, is able to ascertain much about a patient's health by inspection and smell (yes), a market practitioner does the same with the market. 

With the likelihood of QE3 remaining shrouded in speculation, commodities are likely to experience bouts of volatility, driven by the vicissitudes of QE3 banter. India, meanwhile, may track developments on the interest-rate front, with a rate cut fuelling optimism. For now, optimism needs a pair of strong legs, something that seems in short supply, to morph into confidence. 

Till then, Happy Easter! 

'Prediction is very difficult, especially about the future.'
- Neils Bohr, Physicist