Monday, September 24, 2007

VIX:SDS Ratio a Keeper?

I’ll be the first to admit that I keep track of a boatload of silly VIX charts (hey, it’s better than a house full of cats…) that no person in their right mind should ever bother with, but every now and then one speaks to me in a convincingly enough fashion that I keep going back to it.

So here I am with the VIX:SDS ratio chart again. Alan Greenspan says that the holy grail of market forecasting is a fear vs. euphoria indicator. Frankly, this one is good enough for me – at least for the moment. Given that the SDS ETF has only been around since July 2006, there is little in the way of historical information with which to do some backtesting, but I like how the VIX:SDS ratio has been acting during the recent market action. The ratio may not be a perfect way to decompose the fear and volatility components of the VIX, but it certainly offers a fair share of clues. One way to look at the current reading, for instance, would be to interpret only a small fear premium built into the ratio vis-à-vis the more ‘normal’ sentiment expressed by the 100 day SMA.

If anyone has thoughts on this indicator – pro or con – feel free to use the comments section below to make your opinion heard.

7 comments:

Charles Butler said...

If I'm not mistaken, you're merely dividing the VIX by the ETF. Right? Seems to me you you should be comparing rates-of-change, at least as far as the latter is concerned, seeing as one element is reverting and the other, trending. Although I suppose that's what the 100 day average is meant to accomplish.

Cheers

Bill Luby said...

Yes Charles, the chart is simply the VIX divided by the ETF that attempts to track 2x the inverse of the SPX.

Apart from this simple VIX-SDS relationship, I am working behind the scenes on a better description of the relationship between the VIX and the SPX -- and precisely to your point -- a better description of the varying rates of change in these two indices. I should have something up on this soon, but I like the 10/100 SMA for a quick and dirty visual.

Regarding a ratio of an oscillating average vs. a trending one, that is something I have railed against here in the past, but if you are looking at ST data such as the 6 months in the chart above, it is not a significant issue.

Thanks for your input,

-Bill

Felix said...

Bill,

I'm afraid I'm not a big believer in the existence of holy grail indicators for market forecasting, all due respect to Greenspan or you notwithstanding.

That said, as I write this, the SPX seems to be turning downward slightly, and the VIX is headed upward -- as your latest VWSI readings suggested would happen.

But perhaps we should consider reversion to the mean to be less about forecasting and more an observable (and not entirely predictable, at least in terms of timing) phenomenon.

As for the VIX:SDS ratio, I'm not entirely sure of the reason to use an inverse ETF, instead of the SPX itself, and multiplying it to the VIX. You may want to scale the results to get 'nice' numbers, but the shape of the chart should be similar to that of the VIX:SDS -- with the advantage that you won't need to worry about tracking error to the index.

I'm sure you aware that when using 'derived' indicators like VIX:SDS, it's important to keep track of what's being measured. I'm not at all sure of that in this case. If the SPX goes up, both the VIX and the SDS tend to go down, the opposite occurs when the SPX goes down. I guess the ratio gives us a way to see whether VIX is increasing/decreasing faster than than twice in the inverse of the SPX, but what does that really mean, in terms of the market?

Or am I missing the point entirely? Is the intent to trade the VIX against the SDS?

Regardless, I find your blog/posts enjoyable and thought-provoking... while I wait for Mr. Market to make up his mind, lol!

Best regards,
Felix

p.s. Nothing wrong with keeping track of a bunch of silly charts... you might be surprised by the clutter in the attics of my mind. Or maybe not, lol.

Bill Luby said...

You've hit on some good points, Felix, and we are in strong agreement here.

Some comments/clarifications:

1) the use of the VIX:SDS ratio is indeed less exact than a simple multiplication of -2x * SPX, but StockCharts has the tools to do the former and not the latter, so that's why I went down that path.

2) regarding the speed of the VIX and SDS movements in the opposite direction of the SPX, while the SDS ratio is (approximately) fixed, the VIX ratio varies considerably. About 20% of the time the VIX is positively correlated to the SPX and the negative correlations tend to get extreme as emotion exceeds volatility -- so that there is not really a 'normal' linear mathematical relationship between the VIX and SPX, but instead a power function that is curved, with part of that curve being, IMHO, a fear component.

3) I had hoped to have more to say about this, but lately I have been trading so much that my R&D efforts have largely been put on hold. Still, I will attempt to quantify the mathematical relationship between the SPX and VIX soon.

4) I hadn't thought about trading the VIX against the SDS, but that is an interesting idea...

As an aside, your "attics of my mind" triggered a rush of the Grateful Dead's "Attics of My Life" and now I find myself listening to The Dead while trading, a first.

Good listening and good trading,

-Bill

Woodshedder said...

Can't go wrong with the Good Ole Grateful Dead.

Damian said...

Whenever I look at something like this, I ask myself how I would trade it from a system point-of-view. Looking at what you've got there, I don't see anything that would work. I'd be curious to hear what you're thinking in terms of actually trading on the information.

Bill Luby said...

Hi Damian,

I'm looking at systems that are similar to that of the PCVXO and use extreme sentiment level divergences (ST vs. LT) to generate buy and sell signals.


I will outline some of my thinking here at a later date, but I'm not sure how much I will get into the details.

Cheers,

-Bill

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