Buy into options smile, recommends Morgan Stanley

Declining demand for payer credit options (the right to buy protection) in recent weeks means that it is now cheaper to buy these options than at any time since the collapse of Lehman Brothers in absolute price terms, says Morgan Stanley in a report published on Friday. If skew turns into a smile, the bank’s analysts point out that the previous imbalance of appetite for payers compared to receivers (the right to sell protection) has moderated somewhat during the summer.

Meanwhile, the tighter index spreads are making out-of-the money options cheap on a dollar price basis, producing a rare smile in iTraxx and CDX option prices (with out of the money options implying higher volatility than at-the-money options). Morgan Stanley recommends buying out-of-the money options for investors who are not long credit but would like defensive exposure. This is a shift in the bank’s recent view that investors should sell volatility.

The report suggests a risk-reversal strategy of selling the March 2010 110 strike payer option on iTraxx and buying the 70 strike receiver at the same maturity. For a similar exposure on CDX, investors could buy the March 2010 90 receiver and sell the 130 payer.