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www.morganmarkets.comGlobal Equity Derivatives &Delta One Strategy
08 December 2011
Global Derivatives Themes
2012 Outlook for Equity Derivatives
Global Equity Derivatives & DeltaOne StrategyMarko Kolanovic
(1-212) 272-1438MKolanovic@jpmorgan.comJ.P. Morgan Securities LLC
Davide Silvestrini
(44-20) 7777-1018davide.silvestrini@jpmorgan.comJ.P. Morgan Securities Ltd.
Tony SK Lee
(852) 2800-8857tony.sk.lee@jpmorgan.comJ.P. Morgan Securities (Asia Pacific) Limited
Michiro Naito
(81-3) 6736-1352michiro.naito@jpmorgan.comJPMorgan Securities Japan Co., Ltd.
See page 41 for analyst certification and important disclosures, including non-US analyst disclosures.
J.P. Morgan does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm mayhave a conflict of interest that could affect the objectivity of this report. Investors should consider this repor as only a single factor in making their investment decision. In the United States, this information is available only to persons who have received the proper option risk disclosure documents.Please contact your J.P. Morgan representative or visit http://www.optionsclearing.com/publications/risks/riskstoc.pdf.
In 2011 we witnessed two distinct market regimes: very low volatility inH1, and extreme correlation, poor liquidity and high volatility in H2.Escalation of European sovereign credit crisis in August caughtinvestors by surprise,triggering a series of large risk on/off flows. Therecord drop in equity liquidity and the rise of cross-asset correlationseffectively shut off equity markets for fundamental stock investors. Inaddition, derivative hedging flows at times overwhelmed liquidity,further adding to market volatility and correlation.
Political risk is currently the main driver of market volatility.Uncertainty related to the European monetary and fiscal policies hasdisadvantaged holders of risky assets. In addition, the capacity of thefinancial system to store risk has been diminished by ongoingdeleveraging and by regulatory changes that have eliminated proprietarydesks and increased the cost of capital. The diminished risk-takingcapacity has resulted in large dislocations in implied correlation, skew,convexity, long-dated volatility, and dividend markets.
In 2012, we expect a decline in volatility relative to H2 2011. Despitelingering macroeconomic, political and geopolitical risks, we believe thatcyclical forces willlikely reduce what we believe are unsustainablelevels of correlation and risk premium. We recommend that investorsimplement trades that have a short skew, short correlation and shortconvexity bias, as these metrics are all currently expensive, in our view.
In the second part of this report, we recommend a number of trade ideasthat incorporate our market and volatility views. In particular, we suggestthe following:
Risk Premium Trades– 
sell index skew through putladders, put ratios and barrier options; sell convexity on the Nikkei 225and Hang Seng; sell correlation on the ASX 200, FTSE 100 andS&P500; sell long-term variance on the S&P 500; long protected upsideon 2013 EuroSTOXX50 dividend futures;
Downside ProtectionTrades– 
hedge risk-off events with selected global index puts; hedgegeopolitical risk with “Iran puts”(S&P 500 puts contingent on oil pricesrising); hedge volatility risk with May-12 VIX call spreads; hedge HongKong bank risk with a best-of put;
Relative Value Trades– 
sellS&P500 variance,buy KOSPI variance; EM vs. DM outperformance;and European single-name credit-equity trades;
Upside ParticipationTrades – 
 buy OTM calls on derated names in Europe; bullish Japancalendar spreads.
Marko Kolanovic
(1-212) 272-1438mkolanovic@jpmorgan.comJ.P. Morgan Securities LLC
Davide Silvestrini
(44-20) 7777-1018davide.silvestrini@jpmorgan.comJ.P. Morgan Securities Ltd.
Tony SK Lee
(Asia Pacific)
(852) 2800-8857tony.sk.lee@jpmorgan.comJ.P. Morgan Securities (Asia Pacific) Limited
Michiro Naito
(81-3) 6736-1352michiro.naito@jpmorgan.comJPMorgan Securities Japan Co., Ltd.
Equity Derivatives Strategy TeamUS
Marko Kolanovic
 Adam Rudd
 Amyn Bharwani
Kapil Dhingra
Min Moon
Davide Silvestrini
Bram Kaplan
Peng Cheng
Rahil Iqbal
Asia Pacific
Tony Lee
Sue Lee
Clara Law
Michiro Naito
Hayato Ono
Global Equity Derivatives & Delta One Strategy
08 December 2011Marko Kolanovic(1-212) 272-1438MKolanovic@jpmorgan.com
Table of Contents
Global Equity Derivatives & Delta One Strategy
08 December 2011Marko Kolanovic(1-212) 272-1438MKolanovic@jpmorgan.com
Equity Derivatives Outlook
2012 Global Volatility Outlook
During H1 2011, equities were in a low volatility regime with S&P 500 realized volatility reaching pre-Lehman low levelsof ~12%(Figure 1). The low volatility regime of H1 was caused by a strong market performance in H2 2010 that triggered arecord decline in equity correlations(Figure 2). Over the same time period, market liquidity reached new highs, andderivative hedging activity put downward pressure on realized volatility
.Given the positive macroeconomic sentiment andstrong technicals (high liquidity, low correlation), even turmoil in the Middle East and the nuclear disaster in Japan inMarch did not result in a significant increase of equity volatility.At the end of July, renewed concerns about European sovereign debt, the sustainability of US growth and fears of another global recession caused rapid market deterioration. Large risk on/off flows between government bonds and risky assets suchas equities, commodities and currencies caused cross-asset correlations to reach all-time high levels(Figure 2). These macrorisk on/off flows were transmitted to equities largely through index trading, giving rise to a record level of equity correlation(stock-to-stock correlation).As most equity flows have been implemented with index instruments (e.g., futures and ETFs), equity volatility has beendriven by risk on/off flows and the significantly reduced liquidity of equity index products.Figure 3shows the liquidity of S&P 500 E-mini futures as measured by the number of contracts bid/offered within 5 futures ticks (1.25 index point). InAugust, liquidity dropped by more than 70% compared with the beginning of H1. It is interesting to note that the H2changes in correlation (100% increase) and liquidity (70% decrease) were larger than changes in other equityrisks, andwere the key drivers of equity volatility, in our view.The drop in equity liquidity in H2 suggests that the current system has significantly reduced capacity to store equity risk.This may be related to regulations (e.g., elimination of proprietary desks, increased capital requirements) and changes in thestructure of equity liquidity, i.e., the increased role of computerized trading in liquidity provision
. High levels of correlationand low liquidity further discouraged fundamental equity investors from trading stocks. For that reason, a significantamount of stock trading in H2 was the result of index and statistical arbitrage programs putting further upward pressure oncorrelations. This hostile risk on/off environment started undermining confidence in equities as an asset class, resulting in persistent outflows from US equity mutual funds during H2(Figure 3).
See our H2 2011 Volatility Outlook for Discussion of Structural Pressure on Equity Volatility in H1 2011 due to long gamma positions.
This liquidity can quickly disappear, such as during the flash crash in May 2010.
Figure 1: S&P 500 Realized Volatility and the VIX –Note distinctregimes of volatility in H1 and H2 2011, and different duration of 2010 and 2011 volatility spikes both related to European debt crisis
Source: J.P. Morgan Equity Derivatives Strategy.
Figure 2: Cross-asset and equity correlations recently reached all-time high levels. High correlations are the maindriver of equityindex volatility.
Source: J.P. Morgan Equity Derivatives Strategy.
101520253035404550Feb, 10Jun, 10Nov, 10Mar, 11Jul, 11Nov, 11
   3   M   R  e  a   l   i  z  e   d   V  o   l  a   t   i   l   i   t  y   V   I   X
10%20%30%40%50%60%70% Nov, 01May, 04Nov, 06May, 09Nov, 11
1Y Average Correlation of Risky Assets at All-Time High
Equity Correlations at All-Time Highs
H2 '10H2 '11H2 '08

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