Thursday, December 31, 2009

VIX and More 2009 Year in Review

While I thought the Top Posts of 2009 captured many of the high points on the blog during the past year, I also believe it might be interesting for readers to hear about which posts were some of my favorites.

Looking back at everything I wrote in 2009, I suspect that my most important work was probably with VXX, the iPath S&P 500 VIX Short-Term Futures ETN. I believe I was the first to analyze VXX in any detail, discuss some of the shortcomings and ultimately tie it all together in Why the VXX Is Not a Good Short-Term or Long-Term Play. Along the way, I think VXX Calculations, VIX Futures and Time Decay was the piece that shaped the thinking of many investors. In terms of timeliness, VXX Juice Factor and Portfolio Insurance Implications was a warning shot I fired in the first month after VXX was launched.

While volatility declined almost in a straight line for the entire year, stocks did not. In retrospect, The Possibility of a ‘Stealth Bottom’ was one of my best predictions and my March 5th SPX at 687; Intermediate Bottom Potential Is High was only one day early.

Some of my favorite posts of the year were related to how to think about trading. The Trader Development Stage Model – Version 2.0 was a way for me to articulate some of my thinking on the subject of how traders evolve. In The Trader Development Stage Model and the Jump from Stocks to Options I liked how the model explained how and why new options traders get into trouble. A precursor to the model was a pair of posts Kafka, Surrealism and Trading and Comfort Zones, Focus and Thinking Like a Biotech Firm which address trading strategy development. Earlier in the year, Can Options Selling Make You a Better Trader? probably got the wheels turning about some of the elements of superior trading performance.

In another impromptu series of posts, I dipped my toe into behavioral finance in Availability Bias and Disaster Imprinting. The ideas from that post became much more compelling when I tied them back to the VIX in The VIX:VXV Ratio, Availability Bias and Disaster Imprinting and later in VIX Data to Support Availability Bias and Disaster Imprinting Hypothesis.

It turns out that the behavioral finance posts and several posts on realized volatility shared some analytical ideas. In The Gap Between the VIX and Realized Volatility I posted my what I believe is my first graphical representation of the difference between the VIX and realized volatility. When that extended gap finally came to an end, I posted about it in Chart of the Week: No More Free Lunch for Volatility Sellers?

With other voices now regularly discussing the VIX, I don’t feel the need to post on that subject as much as I once did, but my incredulity recently boiled over in The VIX Spike Conundrum after I saw many pundits essentially suggesting that investors panic along with the crowd.

Last but not least, two of my favorite humorous interludes were Roubini and the VIX and Blogging Network a Better Buy than Business Week?

On a personal note, I am delighted to say than in many instances it was reader comments and private emails which provided the inspiration and kicked started a dialogue of ideas that eventually resulted in some of these posts. I continue to be surprised by the extent to which blogging is a collaborative process and am thankful to all who have made my life richer in 2009 by sharing their questions and insights.

Disclosure: none

Wednesday, December 30, 2009

Opinions Wanted: Predict the VIX on 12/31/2010

Let's see how well the wisdom of the crowds works.

Instead of a simple poll, I am curious not just where readers think the VIX will be at the end 2010, but also what some of the more important forces acting on volatility will be in the coming year.

So go ahead and make those comments sing...

Disclosure: none

Tuesday, December 29, 2009

Some Blogroll Highlights

As the year winds down, many traders and bloggers have put things on autopilot. While this is understandable, on my blogroll I noticed several important exceptions to this rule. Four blogs – three of which were launched in 2009 – have consistently hit high notes during the year and just happen to do so again during this slow period.

Rob Hanna at Quantifiable Edges is the multi-year veteran of the group. For those who may not be familiar with Rob’s work, he has compiled Quantifiable Edges Greatest Hits of 2009. This monthly retrospective may be the perfect introduction to a blog that is an excellent resource for those attempting to make the jump from a stock picker to a master of indicators and strategies.

Two other quantitatively-oriented strategies and systems guys just happened to be out with fine complementary pieces today. Like Rob, Frank at Trading the Odds can be counted on for thorough research and analysis covering a wide variety of strategies, which is always captured in a compelling and comprehensive manner. A former frequent commenter at VIX and More, Frank decided to set up his own electronic canvas earlier this year to have a more organized platform to share his thinking – and we are all better off for it. Today’s How to Make a Million (%) Trading the SPYDER – Part One is a fine example of Frank’s approach, leaving the reader with substantial food for thought and the promise of some excellent courses still to come.

In looking at David Varadi’s CSS Analytics blog, I was stunned to see that the blog is less than a half a year old. With all the high quality content that David has managed to shoehorn into just a few months, I’m sure my oversight can be forgiven. If this sounds like hyperbole, check for yourself. Start with today’s Relative Strength 101 and keep reading back in time until you lose interest. Warning: July comes up faster than you think…

Last but certainly not least is Tyler Craig’s options-oriented Tyler’s Trading. Today Tyler assembled a Blast from the Past which captures his top ten posts of the year. For the beginning to intermediate options trader, these articles combine important topics, excellent graphics, and facile prose.

Apart from coming up with something interesting to say on a regular basis, my biggest challenge here is undoubtedly maintaining an up-to-date, high quality blogroll that incorporates a wide variety of interests and perspectives from a mix of popular and semi-obscure bloggers. There are few things as invigorating, however, as discovering a fresh new voice. Let’s hope 2010 proves to be as fruitful in this regard as 2009 was.

Disclosure: Quantifiable Edges and the VIX and More Subscriber Newsletter are available as part of a bundle (with ETF Rewind) in Blogger Triple Play

Monday, December 28, 2009

Top Posts of 2009

As this blog starts to get a little long in the tooth, I am having more fun scanning the archives to see what I was writing about and readers were responding to as various events were pushing the markets up and down.

This marks the third year I have assembled my top posts of the year collection, which represents the 25 posts of 2009 which have been read by the largest number of unique readers during the course of the year:

  1. Chart of the Week: Might Recent Volume Bottom Doom Stocks?
  2. SPX 15% Over 200 Day Moving Average for First Time in Ten Years
  3. How to Trade the VIX
  4. Lagging Semiconductor Index Suggests Caution
  5. The SPX and the 200 Day Moving Average
  6. Trader Development Stage Model – Version 2.0
  7. Draft Trader Development Stage Model
  8. VIX:VXV Ratio Sell/Short Signal
  9. The Possibility of a ‘Stealth Bottom’
  10. VIX at Seasonal Cycle Low
  11. On Trading Rules and Guidelines
  12. Three Fear Indicators (or…The Three Baritones)
  13. VXX Calculations, VIX Futures and Time Decay
  14. Chart of the Week: Change of Trend in Cash Holdings?
  15. Lost in Translation: VXX and VXZ
  16. VIX:VXV Ratio Moving Toward Bearish Zone
  17. Equity Put to Call Ratio Hits Ten Month Low
  18. VIX Spike of 35% in Four Days is Short-Term Buy Signal
  19. New Dr. Brett Series on Lessons for Developing Traders
  20. Triple ETF Options Landscape
  21. Cash on Sidelines Headed Back to Stocks?
  22. Eerie Déjà Vu as Both VIX and SPX Jump More than 2.5%
  23. Options Expiration Weeks and the March to August Bull Market
  24. Learning About Options (1)
  25. Commercial Real Estate Problems Piling Up

For the record, the top 25 posts for 2007 and 2008 are pinned to the right hand column of the blog and can also be plucked from the archives at:

Alternatively, readers looking for a month-by-month review of the past three years may be interested in The Post of the Month: An Informal History of VIX and More

Disclosure: none

Sunday, December 27, 2009

Chart of the Week: An Incredible Year for Junk Bonds

It is that time of year where investors look back at 2009 and ahead toward 2010.

In looking back at 2009, investors who were fortunate enough to time the March bottom have been able to take advantage of most or all of 68% gain in the S&P 500 index since that bottom. While stocks have been on a tear for the past 9 ½ months, I would hazard to guess that quite a few investors do not realize that for the most part, junk bonds have performed as well as equities during this period.

In this week’s chart of the week, below, I show the almost identical performance of SPY (SPDR S&P 500 ETF) and JNK, a junk bond ETF formally known as the SPDR Barclays Capital High Yield Bond ETF (holdings). Amazingly, since the March 9th bottom in stocks, JNK has matched SPY step for step – and with less volatility.

If the U.S. economy continues to rebound in 2010, it is possible that junk bond ETFs such as JNK and HYG will keep pace with stocks going forward. At the very least, these ETFs offer investors some portfolio diversification and less volatility – even though these are an extremely risky asset class.

For more on related subjects, readers are encouraged to check out:

[source: StockCharts]

Disclosure: none

Thursday, December 24, 2009

VIX and More and the 2010 Bespoke Roundtable

Just a quick note to let readers know that Bespoke Investment Group is out with their 2010 Roundtable and VIX and More was one of the dozen participants who put their necks – and ideas – out on the chopping block.

In the past I have resisted looking ahead with predictions for the coming year for several reasons, not the least of which is that most of my trading is driven by technical and market sentiment factors that have a strong predictive power for up to a month or so and on rare occasions two expiration cycles or more. Looking out more than two months means that I have to swap my technical/sentiment hat for a macroeconomic/fundamental one and as soon as that happens it seems as if my predictive ability is no better than the wisdom of the crowds – which is not surprising given that the best in the world struggle to be right 60% of the time according to CXO Advisory Group’s guru grades.

In any event, Bespoke has published both the highlights from all the responses, as well as a PDF of all the individual predictions and commentary, including the 2010 VIX and More PDF.

Thanks to Bespoke for pulling together an excellent group of pundits. Hopefully, somewhere among the spectrum of ideas presented there are a couple of nuggets for each investor.

Readers may wish to ponder each of the questions and issues raised by Bespoke in the next week or so and consider the implications for their investment approach in 2010. Of course if eggnog takes priority over contemplating all the possible housing market scenarios, I can certainly understand that too…

Merry Christmas and happy holidays to all.

Disclosure: Long eggnog

Wednesday, December 23, 2009

Some Approaches to Trading ETFs

Two days ago in ETFs Increasingly Dominate Trading, I mentioned that this blog will devote more attention to ETFs in the coming year. I have also decided that after three years of dancing around the subject, I will also be a little more explicit in talking about different strategic approaches to trading as well as specific strategies.

Yesterday, while I was thinking about where these two new focal points intersect, I noticed a timely piece from CXO Advisory Group with the title of Simple Sector ETF Momentum Strategy Performance. The article, which looks at three different sector SPDR momentum strategies, ultimately concludes that “simple sector ETF momentum strategies have generally outperformed the broad stock market over the past decade for reasonably low trading frictions.” As someone who actively trades sector rotation strategies, I can’t say I was surprised by the results, but I thought the analysis and charts made for excellent reading – and are certainly worth a click through.

Speaking of sector and geography ETFs, I was also recently examining some of the work that TradingMarkets.com has done with ETFs in the context of their ETF PowerRatings. Anyone familiar with the work of Larry Connors will see how some similar themes from previous publications have been adapted to the ETF world. Based on some introductory materials and a review of charts such as the XLY chart below, it appears as if the ratings give the highest marks to ETFs that have shown intermediate-term trend strength, followed by a recent pullback. In other words, the ratings make it easy to get long up trends or short downtrends after a pullback makes for high probability entry signals. Frankly, this is the type of strategic approach that I have had a lot of success with and it appears that the ETF PowerRatings implementation is a similar application to some of my thinking about ETFs.

If the TradingMarkets approach appeals to the investor who is looking for someone else to do all the analysis and generate entry and exit signals, ETF Rewind is at the other end of the spectrum. In ETF Rewind Pro, Jeff Pietsch has built an Excel-based set of data and analytics that is ideal for the ideal for the investor who likes to do their own analysis and roll their own strategies, but needs a platform on which to make it all happen. Earlier this year, in Pairs Trading with ROB, I talked about some of the pairs trading applications that ETF Rewind can be used for. I failed to mention that ETF Rewind also comes with modules that generate both long and short weekly trend trading ideas, daily countertrend trading ideas and day trading candidates as well. Of course, most investors will also want to avail themselves of the almost encyclopedic collection of data for almost 200 ETFs and use the data and tools to develop their own strategies.

I should also note that I have a subscriber service which I rarely discuss here that utilizes a volatility-based ETF trading approach that I call EVALS (ETF Volatility Analysis Long/Short.) EVALS is unusual in that it is a trading approach which draws upon volatility-based indicators to trigger entries and exits. For more information, try VIX and More EVALS or check out the EVALS blog.

For more on related subjects, readers are encouraged to check out:

[graphic: ETF PowerRatings and TradingMarkets.com]

Disclosure: ETF Rewind and the VIX and More Subscriber Newsletter are available as part of a bundle (with Quantifiable Edges) in Blogger Triple Play

Tuesday, December 22, 2009

Historical Volatility and Seasonality Push VIX Below 20

The CBOE Volatility Index (VIX) slipped below 20.00 for the first time since August 2008, ultimately closing at a 16 month low of 19.54 today.

When I called for a sub-20 VIX last Wednesday in Historical Volatility Pointing to a Sub-20 VIX, the crux of my argument was that “if HV [historical volatility] continues to fall, the case for a 20+ VIX will deteriorate rapidly. Substantial divergences tend to have a relatively short life. With the current divergence now at six trading days, the VIX can only defy gravity for a short while longer.” I further noted seasonal factors (such as the holiday effect) at work and was also emboldened in my prediction by what I call calendar reversion – the tendency of the VIX to fall an extra 1% or so on Fridays due to market makers adjusting prices ahead of the weekend to compensate for the mismatch between the five day trading week and the seven day calendar week.

Now that the VIX has closed below 20, however, there is no reason to assume it will not go lower. Even without accounting for seasonal factors, which include a 3 ½ day trading week this week followed by a 4 day trading week next week, current historical volatility data suggest a fair value for the VIX in the mid-17s.

While I think we have a while to go before investors are comfortable with a VIX that is more than a point or two away from the 20s, today should go a long way toward muting the cry that a VIX of 20 is sufficiently low to necessitate a selloff in stocks.

For more on related subjects, readers are encouraged to check out:

[source: StockCharts]

Disclosure: none

Monday, December 21, 2009

ETFs Increasingly Dominate Trading

During the course of 2009, my trading transitioned from a lifelong habit of focusing primarily on single stocks to rapidly making exchange-traded funds (ETFs) my favored means by which to trade stocks and options. Just three years ago, ETFs accounted for less than 10% of my trading. In 2009, that number will be close to 80%.

The headline above could just as well apply to ETFs as a whole, where there are now over 100 issues that average in excess of one million shares traded per day. Just using ETFs from the million share club, an investor can go long or short stocks, use leverage, pick from a wide variety of sectors, tackle geographies as off the beaten track as Malaysia, make use of junk bonds and inflation-protected bonds, dive into commodities or real estate, and even take a position on the VIX. Better yet, most of these ETFs have options associated with them, which further broadens the investing opportunities that are available.

I am particularly fond of ETFs because of the broad range of asset classes, sectors, geographies and other investment ideas they make easily accessible. For the options trader, ETFs are a boon because these investment vehicles all but eliminate single stock risk in the form of earnings, M&A activity, executive shuffles, legal matters and a myriad of other company-specific events.

In 2010 I intend to give more attention to ETFs in this space in hopes of educating and encouraging those for whom the rapidly expanding ETF universe is a good fit for their trading goals and approaches.

For more on related subjects, readers are encouraged to check out:

Disclosure: none

Sunday, December 20, 2009

Chart of the Week: Dollar Approaching Resistance on Weekly Chart?

Try as I may to find something other than the dollar to highlight in chart of the week, I find the dollar’s story to be too compelling to overlook. Also, to the extent that this weekly chart is supposed to reflect an issue that I have been contemplating at some length as of late, I see the dollar as one of the key elements of the 2010 investment puzzle.

In order to get a better sense of the dollar, this week’s chart of the week looks at five years of weekly bars in the dollar index, which compares the dollar to a weighted average of a basket of foreign currencies that includes the euro, Japanese yen, British pound, Canadian dollar, Swedish krona and Swiss franc. Of these currencies, the euro has by far the largest weighting in the basket at approximately 57.6%. For this reason, concerns about Dubai, Greece and Spain have not only significantly weakened the euro, but because of the euro’s weighting, have had a strong bullish effect on the dollar index.

The chart below shows that the 79 level in the dollar index represents resistance in the form of converging 39 and 100 week moving averages. On startling feature in the chart is the 100 week moving average, which has held steadfast in the high 78s for 16 straight months, even as the dollar index has fluctuated wildly during the financial crisis. Should the dollar close above 79 and take out both moving averages, I would have to consider it back on a bullish trajectory. For now, however, I am content to count the recent move as a technical bounce that has resulted from a series of threats to the European economy and its currency.

For more on related subjects, readers are encouraged to check out:

[source: StockCharts]

Disclosure: none

Friday, December 18, 2009

200 Days Since March 6th Bottom

Just a quick note to inform those who follow such things that today marks 200 trading days since the March 6th bottom.

Among other things, this means that for those who watch the 200 day moving average, these averages are going to start to accelerate their already rapid upward move, as old lows begin to scroll off of the lookback window. In order to show how quickly the 200 day MA is moving, two months ago the S&P 500 index was just about exactly where it is now. At the time, the index was more than 20% above its 200 day MA of about 909, which I took as a signal that equities were getting overheated. Fast forward two months and with the SPX at the same level, the index is now only 13% above the 200 day MA, which is currently at 969 and is advancing at a rate of more than two points per day.

Bulls will probably interpret a rising 200 day MA as an indication that support levels are rising. Bears will undoubtedly see any sort of convergence with the 200 day MA level as a sign that the distance to a bear market is decreasing. For now I am in the bull camp, but an extended range-bound drift is starting to look increasingly likely.

For more on related subjects, readers are encouraged to check out:

Disclosure: none

Wednesday, December 16, 2009

Historical Volatility Pointing to a Sub-20 VIX

Just as I get in an extended discussion of historical volatility (HV), I note that the combination of 10/20/30/50/100 day HV has plummeted to levels not seen since mid-October 2007, which happens to be one week after the all-time high in the S&P 500 index.

It is worth noting that back in mid-October 2007 when the similar HV numbers were posted, the VIX was hovering around the 18.00 level.

With the VIX Holiday Crush starting to kick in and the drama associated with today’s FOMC meeting now behind us, I now believe there is about a 50% chance that the VIX dips below 20 in the next two days, even with the E-mini S&P 500 futures (/ES) down 4.50 as I type this. The alternative, which has been the status quo as of late, is that the 20 area acts as support for the VIX and triggers resistance in stocks.

Now the VIX does not have to follow historical volatility religiously, but if HV continues to fall, the case for a 20+ VIX will deteriorate rapidly. Substantial divergences tend to have a relatively short life. With the current divergence now at six trading days, the VIX can only defy gravity for a short while longer…

For more on related subjects, readers are encouraged to check out:

Disclosure: none

Tuesday, December 15, 2009

Adapting Annualized Volatility to Other Time Frames

In Calculating Centered and Non-centered Historical Volatility I attempted to walk through the steps and calculations necessary for determining of historical volatility (HV) using an Excel spreadsheet.

The second to last step in the calculation (before translating the final number into a percentage) is to annualize the standard deviation by multiplying it by the square root of the number of days in a year. In the example I chose, I used 252 trading days, reasoning that there are 365 days per year, 104 weekend days and approximately 9 holidays. One could also argue that while the markets are not open on weekends and holidays, there is market-moving news that makes the jump from Friday to Monday generally more volatility than a typical overnight period. By that line of reasoning, it could be appropriate to use 365 calendar days in the calculation. I am not aware of any options traders that use the square root of 365 in their calculations instead of 252, but note that such an approach would yield a historical volatility number about 20.4% higher (e.g., 18.81 instead of the 15.63 I arrived at in the example in Calculating Centered and Non-centered Historical Volatility.)

Most floor traders simplified the volatility calculation process by assuming 256 trading days in a year. With the square root of 256 an even 16, this greatly simplified the calculations that were done in one’s head.

Not everyone is interested in annualized volatility data. Traders who have options expiring in a week are more interested in determining historical volatility in weekly terms. In order to calculate weekly volatility instead of annualized volatility, simply substitute the square root of 52.14 (the number of weeks in a year) for the square root of 252. The multiplier to determine weekly volatility thus becomes 7.22. Using the example referenced above, the 15.63 per cent annualized volatility translates into 7.11 per cent weekly volatility. A similar approach could be used to calculate historical volatility over other periods, such as a month or perhaps even two years.

Sometimes called statistical volatility or realized volatility, the 15.63 historical volatility means that looking backward, approximately 68% of the time (one standard deviation), the underlying (S&P 500 index) moved 15.63% or less on an annualized basis. Similarly, given the same data set, approximately 68% of the time the underlying moved 7.11% or less on a weekly basis.

Before I wrap up the current discussion of historical volatility, I will use the next two or three posts to talk about how investors might want to use historical volatility data.

For more on historical volatility, readers are encouraged to check out:

Disclosure: none

Monday, December 14, 2009

The BRIC Bull

The last time I wrote about the relative performance of the BRIC countries was a little over eight months ago, in Russia Leading the BRIC Rally. At that time, the bounce off of the March lows was barely a month old and Russia (RSX) was leading the way, followed closely by India (EPI), with Brazil (EWZ) and China (FXI) not rallying quite as sharply.

Fast forward eight months and Russia is still out in front, but starting to look a little tired. For all the talk of a Chinese bubble, FXI, the most popular Chinese ETF, is a distant fourth and falling farther behind the other BRIC ETFs with each passing week. Since the end of October, the top performers have been India and Brazil. In fact the top India ETF (EPI) is now 21% higher than it was the day before the Lehman Brothers bankruptcy, while the Brazil ETF is 29% higher than its was trading just before the Lehman debacle.

Looking ahead to 2010, I expect Russia will have considerable difficulty remaining the top performer. I would not be surprised to see Brazil eclipse the bunch, followed by India and a resurgent China. One thing is certain: if investors can predict the plight of the BRIC ETFs in 2010, quite a few of the other pieces of the investment puzzle will magically begin fall into place.

For more on related subjects, readers are encouraged to check out:

[source: StockCharts]

Disclosure: none

Sunday, December 13, 2009

Chart of the Week: A Month of New Sector Leadership

During the course of the past month or two, stocks have drifted sideways, lacking buying conviction and strong leadership.

In this week’s chart of the week below, I have tracked the performance of the nine AMEX sector SPDRs over the course of the past month. Note that former leaders financials (XLF) and energy (XLE) are now lagging, while defensive sectors such as utilities (XLU) and health care (XLV) are leading the way. Now I have nothing against utilities and health care, but the next time these two sectors lead a significant bull rally will be the first time in my memory. One or more of technology (XLK), consumer discretionary (XLY), materials (XLB) or perhaps financials needs to take a leadership role to give the next bullish leg the type of strength that portfolio managers can believe in.

A good defense may win championship, but it will not light a fire under potential buyers.

For more on related subjects, readers are encouraged to check out:

[source: StockCharts]

Disclosure: none

Thursday, December 10, 2009

Put to Call Ratio and the Probability of a Downturn

In the last day or two I have been fielded several questions about put to call ratios. It seems as if some investors are concerned that there is a stealth movement by sophisticated investors who are making substantial bets on a downward move with large purchases of puts. Invariably, these concerns have led to questions about what I see in the put to call ratios that will confirm or deny this.

To quickly recap, the CBOE publishes three put to call ratios. In my preferred charting site, StockCharts.com, these are known as:

  • $CPCE – the ticker for the equity put to call ratio
  • $CPCI – the ticker for the index put to call ticker
  • $CPC – the ticker for the total equity + index data

For reasons I have discussed in the past, I prefer the CPCE ratio and use this as a contrarian signal. The problem with the CPCI data is that institutional order flow for index options tends to come in large chunks that can create misleading short-term signals.

Recently, however, the CPCE, CPCI and CPC have all had very similar looking charts. I have reproduced the six month chart of CPCE below and it shows no unusual spikes in put activity relative to call activity. If anything, the 10 day EMA that I use to smooth the sometimes noisy CPCE data shows an almost eerie flat line for the past month or so, just as was the case when I last wrote about put to call ratios when in Equity Put to Call Ratio Not Pointing to a Correction when the Dubai debt crisis hit.

For more on related subjects, readers are encouraged to check out:

[source: StockCharts]

Disclosure: none

Wednesday, December 9, 2009

When Did Volatility Bottom?

If an investor were to have a VIX-centric view of the universe, he or she might reasonably conclude that as far as 2009 is concerned, volatility bottomed just before Thanksgiving, when the VIX made its intraday low for the year (20.05 on 11/25) or on the previous day, when the VIX had its lowest close of the year at 20.47.

In fact, if one considers only historical volatility then the lows in historical volatility for the 10 day, 20 day and 30 day measures all fell in the second half of September. Further, an even more comprehensive volatility measure, average true range (ATR), also shows volatility bottoming in the second half of September. As the chart below shows, ATR has not come close to touching its September and October lows during the last month. On the other hand, the VIX is in a more definitive downtrend and continued to make new lows in November.

What does all this mean? In short, it means that even as volatility has flattened out, market expectations of future volatility have continued to decline. With the holiday effect expected to put a more pronounced damper on volatility starting next Monday, I would not be surprised if the VIX takes one last run at the sub-20 level before the end of the year. After the first of the year, however, I would expect historical volatility and implied volatility measure such as the VIX to start to track more closely. Whether this means historical volatility will rise to meet the VIX or the VIX will fall toward historical volatility levels remains to be seen.

For more on related subjects, readers are encouraged to check out:

[source: StockCharts]

Disclosure: none

Tuesday, December 8, 2009

Calculating Centered and Non-centered Historical Volatility

Yesterday in What Is Historical Volatility? I attempted to provide a brief overview of historical volatility (HV) and put it in a broader volatility context.

Today I will endeavor to address the most frequent question I get about historical volatility: exactly how is it calculated?

You would think the calculation would be a straightforward affair, but this is not necessarily the case. As best I can in plain English (and since I have not mastered Word’s equation editor), the steps for calculating historical volatility are as follows:

  1. Select a desired lookback period in trading days (lookback period)
  2. Gather closing prices for the full lookback period, plus one additional day (lookback +1)
  3. Calculate the daily close-to-close price changes in a security for each day in the lookback period (daily change)
  4. Determine the natural log of each daily percentage change (log of daily changes)
  5. Calculate the mean of all the natural logs of the closing prices for the lookback period (log lookback mean)
  6. For each day, subtract the lookback mean from the log of daily changes (daily difference)
  7. Square all the differences between the mean and the daily change (daily variance)
  8. Sum all the squares of the differences (sum of variances)
  9. Divide the sum of the squares of the variances by the lookback period (lookback variance)
  10. Take the square root of the lookback variance (historical volatility, expressed as a standard deviation)

Finally, to convert the standard deviation into an annual volatility percentage take the HV expressed as a standard deviation and multiply it by the square root of the number of trading days in a year (approximately 252) and then by 100 (historical volatility).

An Excel example will help to illustrate the steps and calculations. The table below uses closing data for the SPX for the last eleven trading sessions. The second row has a date of 11/24/09 in column A, a close of 1105.65 in column B and the natural log of the close for 11/24 divided by 11/23 in the column C [=LN (b3:b2)]. Column D is an average of the natural logs in column C [=average (c3:c12)], while column E simply subtracts column D from column C [=c3-d3]. Finally, Column F squares the results of column E [=e3^2] and cell F13 sums all the squares [=sum(f3:f12)].

The calculations below the main table start by repeating the value of F13 in A16 [=f13] and stating the number of lookback periods in A17. In A19, A16 is divided by A17 [=a16/a17]. A21 then takes the square root of the result from A19 [=a19^1/2]. A23 takes the result from A21 and multiplies it by the square root of 252 [=a21*sqrt(252)]. Last but not least, A25 converts to result from A23 to a percentage [=a23*100], yielding a 10-day historical volatility of 15.63.

To replicate the entire table, the formulas from row 3 can just be copied down to the bottom of the table, with one exception. That exception is column D, where the mean value – not the formula – is repeated throughout the table.

If this seems like a lot of calculations to arrive at historical volatility value, there is a much shorter and slightly different way – and one that I believe generates a better number for traders.

The above calculations reflect a centered approach in which daily price changes are characterized relative to a mean value for the entire period. Another way to look at the same problem is to assume that in the long run, the mean change in price approaches zero and is not meaningful. As a corollary, if the mean is not meaningful, there is no reason to subtract it from the daily changes, so all the calculations involving the mean can be dropped. This is the non-centered approach to calculating historical volatility and is sometimes known as “ditching the mean”.

The resulting table below is much more manageable and easier to follow. The first three columns (date, close and natural log of the daily price change) are identical to those above. The fourth column simply takes the standard deviation of the natural log of the daily price changes, multiplies it by the square root of the number of trading days in a year (252) and coverts it to an annualized volatility percentage by multiplying by 100. As a consequence, the formula in cell d12 below is simply =stdev(c3:c12)*sqrt(252)*100. This formula can now be copied to the rows below to calculate subsequent historical volatility values. Note that unlike the centered approach, there are no additional calculations required beyond those in the main table.

Here the non-centered approach also yields a 10-day historical volatility of 15.63.

For the next part in this series, I will expand upon what some of the formulas mean, how they can be modified, and why traders might prefer the non-centered historical volatility data to the centered historical volatility data.

For more on historical volatility, readers are encouraged to check out:

Disclosure: none

Monday, December 7, 2009

What Is Historical Volatility?

The volatility universe splits fairly neatly into two halves: historical volatility (HV) and implied volatility (IV). I tend to place slightly more emphasis on implied volatility because implied volatility looks to the future, is derived from options prices, and can provide some clues about the current sentiment of options investors. Of course, the CBOE Volatility Index, commonly known as the VIX, is an index that measures implied volatility in S&P 500 index options, so that may persuade me to favor IV over HV a little as well.

Compared to implied volatility, historical volatility seems like a relatively simple concept. It looks backward at price action and measures the degree of change in the price of a security. Things get a little more complicated, however, when one asks two seemingly innocuous questions:

  1. How long of a period?

  2. What method of measurement is used?

The issue of a lookback period is really not much of a complication, but it does lead to a proliferation of historical volatility numbers. As historical volatility looks only at trading days, it is important to note that the historical volatility calendar differs from the implied volatility calendar. As a result, the standard implied volatility time horizon of 30 (calendar) days (such as is used by the VIX) translates to about 21 trading days, assuming the usual NYSE nine holidays per year. Even with the different calendars, the most frequently used historical volatility measurement is HV 30, which translates to about 43 calendar days.

The appropriate lookback period to use for historical volatility calculations is ultimately a matter of personal taste. As noted above, most providers of HV data tend to standardize on HV 30, but I generally prefer HV 20 or HV 21, as this is a better approximation of a trading month. One can use shorter time frames, but investors should be wary of the amount of noise in calculations that look back less than 20 days. Still, I like to look at HV 10 to get a sense of the most recent volatility trend. Looking farther out, HV 50 or HV 60 are popular ways to capture almost an entire earnings cycle, while HV 90, HV 100, HV 180 and HV 200 are all excellent ways to capture the long-term volatility trend. In order to incorporate a full year of historical volatility, HV 250 is recommended. Some options traders like to look at two full years of historical volatility data with the likes of HV 500, but I rarely find much value looking back a second year unless – as is the case right now – the most recent year is filled with quite a few statistical outliers.

Any good options broker will have one of more historical volatility calculations built in, but HV data is also available from various options service providers such as Livevol or iVolatility.

Note that standard historical volatility data are the result of a calculation involving close-to-close prices, specifically end of day prices. As such, historical volatility does not capture the magnitude of any intraday price movements, which are better served by calculations such as an average true range.

Finally, while there are many ways to calculate historical volatility, by convention historical volatility is calculated by taking the standard deviation of the difference between the natural log of the daily changes in the price of the underlying and the mean value during the lookback period. This sounds a lot uglier than it turns out to be in Excel. Since this is the holiday season, however, tomorrow I will provide a recipe for the traditional historical volatility calculation as well as a modification that I find simpler and more useful.

For more on historical volatility, readers are encouraged to check out:

Disclosure: Livevol is an advertiser on VIX and More

Sunday, December 6, 2009

Chart of the Week: Dollar Rising?

Friday was a reminder that the dollar will not go down every single day in an orderly, straight line fashion. In fact, there will be days when the dollar reverses sharply and sends traders who are short the currency scrambling to cover their positions, as was the case with Friday’s 1.44% gain.

In this week’s chart of the week below, I track the fall of the dollar and simultaneous rise in the S&P 500 index that began during the first week in March. Since that time there has been only one day in which the dollar gained more than 1.44%. I have highlighted that day with blue arrows to underscore that while the prior large move in the dollar did precede a two week bounce in the currency and a four week selloff in stocks, it did not affect the underlying trend in either the dollar or stocks.

Of course it could be different this time around. For starters, the dollar closed above the 50 day moving average for the first time since mid-April. From a technical perspective, however, I would not tend to get excited about Friday’s rally until it leads to a higher high above 77 and a higher low above 75. For now at least, the current rally should be treated as just another opportunity for some new shorts to join the dollar carry trade party.

For more on the dollar, readers are encouraged to check out:

[source: StockCharts]

Disclosure: none

Friday, December 4, 2009

New Dr. Brett Series on Lessons for Developing Traders

If there is one blog on the web where I never seem to find the appropriate amount of time required to digest all the nuggets of wisdom it contains, that site is undoubtedly Brett Steenbarger’s TraderFeed. Filled with insights that range from quantitative analysis and system development to what is arguably the best collection of content on the web in the realm of trader psychology, TraderFeed continues to be – at least in my opinion – the top all-purpose investment blog on the web.

For this reason, when Brett mentioned in Lessons for Developing Traders: What Moves Markets that he is “going to write about topics that no one told me about when I was learning the ropes,” I thought that instead of waiting until the series is finished to highlight it I would flag it now for anyone who is not already on the Steenbarger bandwagon.

This new series also got me thinking to about the three things I wish I had been told (assuming I was smart enough to follow that advice) at the beginning of my trading career. The answers are personal ones, but I believe they capture insights that led to quantum advances in my trading:

  1. Standardize on one time horizon…and make it consistent with your trading approach and personality

  2. Make research and analysis of risk management at least as important as R&D on stocks, indicators and strategies

  3. Focus more time on developing expertise in managing (and exiting) existing positions than on discovering new high potential entries

For the record, a close fourth in this exercise was understanding the tenets of behavioral finance and the associated decision-making pitfalls that investors should learn to avoid. Those who wish to get a better sense of how I see the learning process for developing traders may wish to investigate my trader development stage model.

Readers, feel free to use the comments section to spell out the 3-4 things you wished someone had told you when you first started trading.

For more on these subjects, readers are encouraged to check out:

Disclosure: none

Thursday, December 3, 2009

VIX of 20 Spurring Market Correction?

As the chart below shows, the last two times the VIX has taken a run at 20 (late October and late November), stocks have responded by selling off and spiking volatility. It is possible that a VIX of 20 may still be something that investors are not yet ready to accept (availability bias), but with historical volatility hovering around 16 and the long-term trend in the VIX still moving downward, it is likely just a matter of time before we see a VIX in the 19s.

In addition to the absolute levels of the VIX, one must always watch relative VIX levels, which is where the moving average envelopes come in. Displayed as a blue zone in the middle of the trading range on the chart, the 10 day simple moving average envelopes make it easy to identify when the VIX is extended to the high side or the low side. While the 20 level has been well out of the moving average envelopes for the last two drops in the VIX, that is not likely to be the case going forward. This sets the possibility of a battle between the absolute VIX (support at 20) vs. the relative VIX (support at the bottom of the envelope) in the near future, with an increased likelihood that the 20 level does not hold the next time around.

Finally, it is that time of year where I feel compelled to remind everyone that seasonal factors also indicate that volatility should be moving lower. I have discussed the holiday effect several times in the past in this space and essentially the historical pattern calls for the VIX to hold relatively steady for the first two weeks of December, then drop sharply (probably about 1.5 points at current levels) as Christmas approaches.

For more on these subjects, readers are encouraged to check out:

[source: StockCharts]

Disclosure: none

Wednesday, December 2, 2009

Where Is VIX and More Headed?

I failed to mention it when it first came out a month ago, but anyone who missed The Periodic Table of Finance Bloggers by Josh Brown at The Reformed Broker not only missed out on a great resource for identifying and classifying some of the top bloggers in the investment world, but also missed out on two elements that are often in short supply in the investment blogger space: subtlety and humor.

I got to thinking about the periodic table when I happened on Horizontal vs. Vertical Blogging from Michael Stokes at MarketSci.

When VIX and More started out, three years ago next month, financial blogging was still in its early stages and the options space in particular was wide open. In fact, Adam Warner at Daily Options Report pretty much had the entire options blogosphere to himself at the time. When I arrived on the scene, I envisioned taking ten minutes or so once a week to recap what had happened with the VIX and volatility during the week so I would be able to have some sort of archival historical overlay of my (almost) real-time thoughts on volatility. At least that was the idea…

Within a couple of days, the idea of a weekly post morphed into a daily post and not wanting to beat the VIX drum day after day, I started branching out into some tangential subject areas. I took up put to call ratios in short order, then expanded into the broader subject of market sentiment, decided to dive into the options space, adopted ETFs and particularly leveraged ETFs, and recently have ventured into behavioral finance, drafted a trader development stage model and have set out on a number of more distant tangents.

Part of the reason for the increase in breadth is to keep the content fresh and to be able to draw connections that are farther afield (e.g., VIX Data to Support Availability Bias and Disaster Imprinting Hypothesis.) Another reason is that I like the variety and never wish to be a slave to routine. Frankly, a third reason for my increasingly horizontal approach is that another wave of options bloggers has taken up the cause in the last year or so. As a result, I no longer feel that if I fail to comment on a particular zig or zag in the VIX or on another subject in my wheelhouse, that it won’t get said.

Before the month is over, I will be delighted to welcome my 1,000,000th unique visitor. So while the content on this blog has unfolded in a somewhat haphazard fashion, I am glad to see that it is resonating with a broad audience.

Going forward, I envision a broader net than might have been implied by the original tongue-in-cheek tagline: “Your One Stop VIX-Centric View of the Universe…” It’s still (mostly) the same universe, but I think it’s time to explore more of the “and More” portion of this blog. Maybe it's time to visit the lighter side more often too...


For related posts, readers are encouraged to check out:

Disclosure: none

Tuesday, December 1, 2009

Equity Put to Call Ratio Not Pointing to Correction

The recent Dubai debt crisis has spurred some investors to take some profits, protect their portfolios and contemplate both the acknowledged and hidden threats to the global economy. From Wednesday’s close to Friday’s intraday low, the S&P 500 index (SPX) only fell 17 points or 2.4%, hardly the type of selloff that typically strikes fear into the hearts of bulls. Fearing that further declines may be in the cards, however, investors snapped up puts aggressively, particularly on Monday, when the put buying pushed the CBOE equity put to call ratio (CPCE) to elevated levels.

In the chart below, I have reproduced the CPCE along with a 10 day exponential moving average (dotted blue line) to smooth the data over a two week period. The chart shows that since the July leg of the current bull market, significant pullbacks in the SPX (solid black line) have been preceded by drops in the 10-day EMA of the CPCE below the 0.58 level. In fact, for the last 5 ½ weeks, the 10-day EMA has never threatened the 0.58 area and at the current 0.625, the CPCE shows no signs of an impending correction.

For related posts on the CPCE, readers are encouraged to check out:

Disclosure: none

DISCLAIMER: "VIX®" is a trademark of Chicago Board Options Exchange, Incorporated. Chicago Board Options Exchange, Incorporated is not affiliated with this website or this website's owner's or operators. CBOE assumes no responsibility for the accuracy or completeness or any other aspect of any content posted on this website by its operator or any third party. All content on this site is provided for informational and entertainment purposes only and is not intended as advice to buy or sell any securities. Stocks are difficult to trade; options are even harder. When it comes to VIX derivatives, don't fall into the trap of thinking that just because you can ride a horse, you can ride an alligator. Please do your own homework and accept full responsibility for any investment decisions you make. No content on this site can be used for commercial purposes without the prior written permission of the author. Copyright © 2007-2013 Bill Luby. All rights reserved.
 
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