corrected transcript FactSet Research Systems Inc. MANAGEMENT DISCUSSION SECTION

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1 MANAGEMENT DISCUSSION SECTION Company Representative Welcome to Perspectives with FactSet. Today we ll be speaking with Phil Guziec, Derivatives Investing Strategist and Editor of the OptionInvestor Service at Morningstar. Today we re going to discuss the current market conditions for investors looking to trade in options and to apply derivative strategies. Phil will also cover what the VIX Index really indicates about investor sentiment and how volatility and change in the market can be interpreted and applied to your investment strategy Copyright CallStreet 1

2 QUESTION AND ANSWER SECTION <Q>: Phil, let s start from a place that all investors are probably familiar with, that s the market volatility that we saw in late 2008 and throughout parts of Where would you characterize where we are now in the market? <A Philip Guziec>: Well, I think it s important to understand what was driving that volatility to understand where we re at now. You could think of the stock market as a mechanism for determining the value of future earnings streams or cash flows in the long run. And in contrast, if we re talking about the option market, you could think of that as a mechanism for evaluating the uncertainty about those future streams of cash flows. So the extreme volatility we ve seen over the last year is basically responses to trying to digest new information. Looking at the potential future streams of cash flows of companies when you have credit crises and questions about the viability of companies and the relationship of financial companies and their viability to the viability of other companies they re lending to, it s hard to estimate if some of these companies are worthless or are going to be generating earnings three years from now. And so that drives the volatility in the underlying equity markets. And then the option markets react to that because they re trying to estimate the uncertainty around the future for the equity market. And since every new piece of news increases that uncertainty or reduces it or swings the value of the potential future cash flows, the option market was reacting to that and you saw extremely high implied volatilities. <Q>: So how stable would you characterize the options market right now as an indicator of maybe what investor sentiment is like right now? <A Philip Guziec>: Well, I think what you re seeing in the option market is a reaction to the major crisis news being behind us. So if you re trying to figure out the uncertainty about tomorrow, and yesterday the market dropped 10%, and we re awaiting a bit of news from the government about what kind of intervention and what kind of solvency, what kind of liquidity programs there are going to be. There s a great deal of uncertainty, but all of those kinds of things have been digested and are behind us. We know that the government isn t going to let any large systemic financial institutions fail from here. We also understand a little bit more about the magnitude of their losses. GDP collapse has slowed. And so now we ve shifted from trying to estimate the extreme outcomes to having the sense of being able to bound the answer and in trying to estimate the range of potential future earnings power of a relatively more stable system now. So characterizing what does that mean for the options market where we re at today, we re seeing stability in the option market reacting to more stability in the financial market, reacting to a better ability to see into the future. <Q>: Phil, I wanted to ask you another question about something that s maybe a broader marketbased question, which is to take a little look at an index that s been on a lot of people s minds throughout the crisis, maybe less so today, which is the VIX, commonly referred to as the Fear Index by the mass media. We saw a lot of fluctuation in the VIX, a large rise in it throughout the crisis, and then a slow, meandering drop since about January What can changes in the VIX really tell an investor as they look at that? And what s that telling us about investor sentiment? <A Philip Guziec>: Well, it s important to understand what the VIX is to understand how to interpret it. The VIX is a measure of the implied volatility of the front month options on the S&P 500 Index. So it s a measure of the uncertainty or the difficulty of bounding the answer of the S&P over the next month. I mean we think about it in terms of volatility, but really the question you re trying to answer is how wider the outcome s going to be. Is it going to be 900 plus or minus 200 points or is Copyright CallStreet 2

3 it 900 plus or minus 50 points a month from now. And it s also important to realize that it reflects both upside and downside scenarios. Because of put-call parity relationships and just the math behind options, when the VIX or any volatility measure spikes it means that both the puts and the calls become expensive. So it s not necessarily a fear gauge; it s an uncertainty gauge. While the VIX is loosely correlated to the implied volatility of individual stock options, it s actually not a great measure of the implied volatility of individual options. The VIX is the volatility of a basket of stocks. And so because of the diversification effect of a basket of stocks versus the underlying individual stocks it s typically lower than the individual stock option implied volatility. So we ve developed the Morningstar Volatility Index or MVI, which is an average of the implied volatility of all the individual stock options weighted by their open interest in the market. And the MVI because of this diversification effect is typically higher than the VIX. But it also has an interesting relationship with the VIX. Because of the diversification effect, in times of panic, the saying goes, all correlations go to one, which means all diversification goes away and the two measures converge. So individual option volatility and index option volatility both spike together and converge towards one. As the market relaxes and is driven by stock-specific news instead of mass macro panic effects, those relationships fall and separate and the individual option volatility starts to become much higher than the index option volatility. So now interpreting that uncertainty gauge independently of the market level, when you see a market drop from 900 to 700 and a VIX that doubles, what s really going on is it s 700, but we don t know if it s going to be 900 or 1000 or 500. If you see a drop from 1100 to 900 and a VIX that remains relatively constant or declines, it means that there was some bad news that came out. It has a negative impact on the future earnings and cash flow streams of the companies in the index, but we now are able to handicap the future from here. So that s why we saw these incredibly high spikes in the VIX during the financial crisis because we couldn t have good visibility into the future. There was an extreme range of outcomes both to the downside and to the upside. There was the fear that you were going to be left out of the upside, so calls and puts became expensive and the VIX got very high, up to 80%. Now what we re seeing is, okay, we re in an ugly recession, we ll come out of it. We re trying to estimate when we ll come out of it, what the growth rate will be coming out of it, but nobody is fearing the Great Depression, so that s why you re seeing a VIX that s decaying down to closer to a more normalized level. <Q>: So if we re going to characterize the VIX as a gauge of market uncertainty and we ve seen that falling, can you talk a little bit about how investors are capitalizing on whatever remains of the uncertainty in the market and just in general the impact of these changes on the options trade? <A Philip Guziec>: Sure. When uncertainty was extremely high, the question as an investor is, is it too high? What s a fair value for it and what s your investment horizon? I like to think of investing as taking a risk along a probability distribution. If you buy an index, you re buying the whole probability distribution. If the index doubles you get the full upside. If it falls in half you get exposure to that. You re exposed to all the swings. When you start using options, you re now dividing that probability distribution up and taking exposure only to the upside or only to the downside or only to some specific wedge or bounded range. Volatility at the historically high levels it was at, it was a great opportunity for fundamental investors who had a sense for how to value some of these securities to sell the mispriced pieces of the probability distribution. So if you had a company that you were sure in a couple years was worth $50, it was trading for 25 and the options at a 25 strike were selling for $10 for a year, you knew that it was like free money, so you could sell those put options. Those kinds of opportunities have been fading. And so anybody who was in the business of selling options through the spikes in implied volatility made quite a bit of money. That opportunity seems to Copyright CallStreet 3

4 be there somewhat. Volatility is still at relatively elevated levels, especially for some individual securities, and going forward depends on what kind of realized volatility we see from here. <Q>: So what should accompany an investor s understanding of market volatility? Give me some idea of how investors can provide context to this given what you ve shared about the VIX. <A Philip Guziec>: I think the key insight investors should get is that all of the pseudo relationships that you hear market pundits using to describe short-term or up or down movements of the market, predicting it based on the VIX, is pretty much hogwash. The VIX is a measure of how tightly you can bound the future, and it contains both the upside and the downside. <Q>: So we talked a lot about the inflated numbers that we saw in the VIX sort of throughout the crisis and especially as fear peaked in the market. How did and could investors have taken advantage of those inflated volatility numbers in their trading? <A Philip Guziec>: Well, when volatility is inflated, especially to unreasonable levels, if you have a handle on the underlying security valuation, you could sell the options. And typically the cost of those options for you when they expire will be much less than what you ve sold them for. So the simplest example is a covered call, which most people are familiar with, or a cash-secured put, which is the exact same payoff as a covered call. And in that scenario the investor, let s say in a covered call, would buy the underlying security and sell the call option. So they would sell the exposure to the upside and any reward related to that and maintain exposure to the downside on the security, and in exchange be paid a premium. And then assuming that that security expired worth more than the strike price of the option, the investor gets to keep the premium. Those premiums were very, very high at the same time that the market was in general undervalued or at a low valuation. So you combine those characteristics and there s a pretty good, reasonable bet to sell those covered calls or sell those put options. And as a fundamental investor and a long-term investor, if you wind up holding the underlying security at the end of the option expiration, you can always sell the call again or write another cashsecured put or just continue to hold the security if the security is put to you and then start to sell calls again. As long as the long-term value is higher than the strike price, typically that strategy will work out well for an individual investor. <Q>: So I wanted to return a little bit to conversation of the VIX in terms of a trading strategy or a hedging strategy. Can portfolio managers use the VIX as a holding to sort of hedge out this concept of volatility? Is that something that you think is valid in a portfolio? <A Philip Guziec>: There s a number of portfolio strategies you can use with the VIX. We should separate strategies that use options within the portfolio from strategies that specifically use VIX futures contracts or VIX futures options. One of the unique characteristics of the VIX futures contract or the VIX itself is the fact that typically in market panic it spikes, which can generate what is called portfolio insurance, or it could generate, if that position was sold, liquidity to make a number of other lucrative investments when other things are typically underpriced. So as a portfolio insurance or portfolio enhancement strategy it could certainly make sense executed properly. Now there s some nuances about the way VIX futures work, and you can t really trade spot VIX as much, and the futures aren t as volatile as the spot VIX. So it s not as simple a strategy to execute as you would think, but it certainly could make sense. A similar strategy would be kind of like the old school portfolio insurance, just buying some far-outof-the-money put options that provide capital or insurance in the event of one of these market Copyright CallStreet 4

5 catastrophe scenarios. And again whether it s leverage and prevention from margin calls or having liquidity to invest when everything else is cheap, it s a valid portfolio management strategy. <Q>: As we mentioned earlier, the VIX has become reasonably more stable in the past six months. It s fallen from some of the record highs we saw. Can you tell me a little bit about how this could impact someone who s running an equity hedge or who s running a similar strategy such as what you re describing using the VIX in various ways in their portfolio? <A Philip Guziec>: In thinking about equity hedge strategies, again I think we need to break it up into strategies that are long-short and hedge that way not using options, which clearly market volatility can be good for them, especially if it s the kind of panic volatility we saw, if they have the cash and the liquidity to take advantage of them. A lot of relative pricing relationships got very out of whack as liquidity driven for selling forced prices just all over the place and betting that those relationships reconverge could be a very profitable strategy executed at the right time. That s different from an equity hedge strategy using options. As we discussed earlier, if you think about an investment as an exposure to a probability distribution or a wedge of it, if you have a strategy that s taking only downside exposure or only upside exposure, rich option prices mean selling options is a good strategy, and inexpensive option prices mean buying options are a good strategy. It just depends on the nuances of how the portfolios are constructed. A purely volatility selling strategy would have worked out well as volatility is falling. And if it continues to fall, it could continue to work out well. And it typically works out reasonably well most of the time. The problem with those strategies is when they don t work, they tend to explode and those funds tend to blow up. <Q>: I wanted to ask you about what clues the VIX gives us about its underlying security and how to strategically invest in them. <A Philip Guziec>: Well, I think the biggest clue that the VIX gives to the underlying security is just how uncertain the market is and what upcoming news events you may need to be afraid of or excited about in determining the value of that security. That security may be based on the bet as of today, the expected value as of today. The market may well know that for one reason or another there s something that s likely to change that in the near future. And anytime you see implied volatility on any underlying security start to increase with the security not moving much should be very aware that there s something likely about to happen and that s getting priced into the option market. Company Representative All right. Well, thank you so much, Phil. Do you have anything else you would like to add before we say goodbye today? Thank you so much, Phil. Philip Guziec, Derivatives Investing Strategist, Morningstar Thanks for having me Copyright CallStreet 5

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