Tuesday, May 29, 2012

A Conversation with Tadas Viskanta of Abnormal Returns

Tadas Viskanta is the founder, editor and curator of the Abnormal Returns blog, where investors come to discover what is important and relevant to their world and bloggers go to see whether their efforts are sufficiently compelling to be included among the hand-selected links that investors pore over at Abnormal Returns each day. Tadas has an MBA from the University of Chicago and a BA from Indiana University. His first book, Abnormal Returns: Winning Strategies from the Frontlines of the Investment Blogosphere, was published a little over one month ago by McGraw-Hill and is available in hardback and digitally in a Kindle edition.

I recently had a chance to talk with Tadas about the blog, the book and a number of issues related to investing. The following is an abridged version of our conversation.

BL: What was it that inspired you to start the blog, Abnormal Returns?

TV: I had a book proposal on hedge funds that had been shopped around and ultimately went nowhere. I had been keeping an eye on the nascent investment blogging scene and WordPress.com had just come online, so I figured that it must be a sign.

BL: When you started, did you have a vision of becoming the destination site for the best financial links or did that happen by accident?

TV: Purely by accident. I found out quickly I wasn’t the fastest blogger and that other bloggers were doing great work. It seemed natural to point to their work rather than do “me too” sort of work. Every blogger has to find their niche.

BL: What has changed in your approach over time?

TV: I just focus on things I’m interested in. I am circumspect in avoiding politics, which means that I also avoid economic policy issues. This frees up a ton of space (and time). I have blogged about the difference between a positive and normative blogosphere. The best posts focus on the data. I’m also getting better at being able to summarize stuff quickly.

BL: Why is it that Abnormal Returns the book appeals to a broader audience than Abnormal Returns the blog?

TV: The blog appeals to sophisticated individual investors and some institutional investors. By contrast, the book attempts to reach a broader audience. My concern is that maybe we bloggers don’t have the tools and vocabulary to reach a broad group of investors. To take an obvious example, Apple hides a lot of sophistication behind technology and there is an incentive for them to take that approach. In finance, those incentives have been ignored to date and financial services firms make money with complicated products and services. Something like a Vanguard balanced fund is a great fund for investors, but nobody is going to make a ton of money giving that type of advice.

BL: What can be done in terms of changing the tools and vocabulary in order to reach that broader audience of investors?

TV: ETFs are one tool, but not a solution in and of themselves. As far as the vocabulary is concerned, it’s a process, not a one-shot deal. We all broadly have the same sort of goals and deal with the same sort of issues. The important thing is to put investors on the path of saving and investing.

BL: What sort of tools or issues do you think most investors should be focusing on?

TV: The goal should be to be an efficient investor. To borrow an idea from tennis, it is important to avoid unforced errors – and specifically to avoid the things that can blow you up. In that regard, the three killers are leverage, complexity and liquidity.

BL: Why do you think investors get into trouble? What are they doing wrong?

TV: The DALBAR studies look at the way fund flows react to performance. Typically investors are buying high and selling low. Some of that has to do with the star manager system. An example is Bill Miller, where most of the money flowed into his fund at precisely the worst time. If you compare balanced funds, you don’t see as much “bad behavior.” With those types of funds, the focus seems to be more on overall portfolio performance, without the desire to tinker with performance.

BL: What are your thoughts on diversification? Is it indeed the only free lunch in investing?

TV: During the 2008 financial crisis there was only one diversification play: U.S. Treasuries. The challenge now is that real yields on Treasuries are negative, so that makes diversification into Treasuries a lot less attractive. There really is no cheap, safe asset at the moment.

BL: Is the interconnectedness of markets and the globalization of the economy a good or bad thing for investors?

TV: It just is. There is nothing anyone can do about increased globalization. You just need to adjust your thinking. The same can be said for any other market-related phenomenon. A lot of traders complain about high frequency trading, but until things change you have to adapt to the environment or find something else to do.

BL: How should retail investors position themselves in light of all the uncertainty in the euro zone? Should they get in cash? Hedge? Ignore the news and sit tight?

TV: The risk of a euro zone breakup is a big risk to the markets. But it isn’t all that different than other big existential risks we face. Investors need to have in place strategies that take into account big market moves. Trying to predict what happens in Europe is a tough game, so having in place a plan before things happen is key. The likelihood you will make sound decisions in the midst of a crisis is pretty small.

BL: Are you a fan of options?

TV: The financial crisis scared a lot of people out of the stock market. The great appeal of options is that they can be used to create structured returns that remove down side risk. I’m not crazy about how options are marketed. For instance, some try to say that covered calls are “income.” This is not correct. The money received for selling covered calls is really compensation for foregoing the possibility of potential gains.

BL: When you think of the concept of “abnormal returns” in terms of the performance statistics of a hedge fund, mutual fund or other investment vehicle, what is your gut reaction? Is it concern that unseen risk lies just below the surface? That such returns are not sustainable? Other issues?

TV: I think there are skilled managers out there who can generate abnormal returns. For investors there are two big issues:

  1. Are the fees they charge going to eat up all of the alpha they generate?
  2. How can we identify these managers beforehand?

It is easy to see which managers outperform ex-post. I talk in the book about how when we examine investment returns we are looking at some mix of skill and luck. Nobody wants to pay a manager for luck, but teasing out who has skill is no easy matter.

BL: Is the quality of information you scan on a daily basis any better or worse than it was five years ago? Are investors getting better or worse information with each passing year?

TV: As good or better. There is probably more noise than there has been prior. That is why it is important to have a strategy to either eliminate or at least filter the noise. Going on a news-free diet can serve this purpose for investors. Most investors have long investing horizons; therefore it makes sense for them to avoid the intraday noise that dominates the financial media.

BL: Many readers of your book are probably worried about whether they will be financially secure in retirement? What should these investors be doing?

TV: First of all, these are personal decisions – when to retire and how much money is enough. There are no right or wrong answers. That is why we call it ‘personal finance.’ Investors should try to push all of the buttons and pull all of the levers that they can to put the odds in their favor. Today’s low yield, low return environment makes this all the more important.

BL: What sort of levers do you think investors should pay attention to?

TV: For many people it is easier to find an extra 1% through more conscious consumption than it is to generate an additional 1% portfolio alpha, for instance. As far as investments are concerned, find incremental returns where you can, including areas such as harvesting tax losses. Ultimately, everyone must understand there are no guarantees.

BL: Thanks, Tadas.

Disclosure(s): none

Friday, May 25, 2012

Investing with a Target Volatility Approach

Since I mentioned one of my favorite ETP sites earlier today [the more I think about it, the more I have come around to the idea that the Best Post of the Year on Exchange-Traded Products may be the best post I have ever seen on the subject] I thought it might be a good idea to include some functionality with that required weekend reading.

Another superb ETP site, ETFreplay.com, recently launched a Volatility Target Backtest tool. What this tool is designed to do is to demonstrate what historical returns would have looked like if one had taken a high volatility ETP such as a leveraged ETP, a VIX-based ETP, etc. and combined with a dynamic cash allocation and historical volatility data to limit exposure to a target volatility ceiling.

An example may make this easier to visualize. Let’s assume that you are bullish on the Russell 2000 index of small capitalization stocks and want to get some long exposure to these stocks with the +2x leveraged ETP, ProShares Ultra Russell2000 (UWM). Last August, however, the 10-day historical volatility in UWM spiked over 160 and right now it is at 41 – and you decide those levels of volatility are unacceptable, particularly with all the uncertainty in Greece and across the euro zone.

The solution? How about a portfolio that dynamically allocates between UWM and cash, (here using the iShares Barclays 1-3 Year Treasury Bond, SHY), based on 10-day historical volatility data and targets a forward volatility level of 20%.

The graphic below shows the ETFreplay backtest results of such a portfolio, using a monthly rebalancing period and starting in January 2007, when UWM was launched.

Of course past results are no guarantee of how this type of strategy might work in the future (and leveraged ETPs certainly entail a great deal of compounding decay risk for long-term investors), but the graphic is compelling, for both bull and bear markets. Think of this type of approach as a way to fine-tune risky products to a desired volatility level.

Enjoy the long weekend, everyone!

Related posts:

[source(s): ETFreplay.com]

Disclosure(s): none

Best Post of the Year on Exchange-Traded Products

Before the long weekend is upon us, I wanted to highlight a real tour de force by Michael Johnston of ETFdb.com: 101 ETF Lessons Every Financial Advisor Should Learn.

Whether you are a novice or have deep knowledge of these products – and irrespective of your role as a financial advisor – there are enough nuggets buried in the article that the best thing for me to do is just supply the link and get out of the way. Enjoy!

Disclosure(s): none

First Day of Trading in Nasdaq-100 Volatility Index (VXN) Futures

You really need a scorecard to keep up with the new product launches at the CBOE. Today was potentially a big one, with the launch of futures on the Nasdaq-100 Volatility Index, which most of us simply refer to as VXN or Vixen.

As the table below shows, the VIX continues to account for approximately 99% of the volatility index futures at the CBOE Futures Exchange (CFE). Today VXN futures (VN) traded 20 contracts on its opening day. While futures in the CBOE Emerging Markets ETF Volatility Index (VXEEM) are currently positioned at the #2 product at the CFE, VXN futures certainly have a lot of potential, with the likes of Apple (AAPL), Facebook (FB) and Google (GOOG) and other technology high fliers folded into this security.

On a related note, for anyone who may be interested, I authored the feature article, The Expanding Volatility Megaplex, in the current edition of Expiring Monthly. This article chronicles the history of volatility indices and looks at how the CBOE has recently begun to aggressively expand the scope of volatility indices and turn these into product platforms for futures, options and exchanged-traded products.

Related posts:

[source(s): CBOE Futures Exchange]

Disclosure(s): The CBOE is an advertiser on VIX and More

Thursday, May 17, 2012

A Million SPX Put Contracts Traded Today…a Contrarian Timing Signal

With a half hour to go in today’s trading session, over one million put contracts have already been traded on the S&P 500 index, which is about 2 ½ times the average daily volume. This elevated put volume comes on top of 913,000 SPX put contracts yesterday, which was the second highest for 2012.

The one million level is rarely seen in SPX puts and generally indicates an extreme amount of hedging on the part of institutional investors, as well as increased speculative activity.

Looking at the chart below, which goes back two years, one can see that in those rare instances when put volume (vertical red bars on lower half of chart) reached one million, this typically coincided with a bottom in stocks.  [Edit:  today’s finally tally is 1.28 million SPX puts, the highest total since August 9, 2011]

In addition to puts in the SPX, I also closely follow the ISEE equities only call to put ratio. The indicator I have developed which is based on the ISEE is now showing is greatest contrarian bullish bias (due to a preponderance of put volume) since the end of June 2010, just two days before the SPX put in an key bottom at 1010.

Of course, history is not guaranteed to repeat itself or even rhyme in the face of the current worries about Greece and Spain, but the odds now favor stocks finding at least a short-term bottom very soon.

Related posts:

[source(s): LivevolPro.com]

Disclosure(s): Livevol is an advertiser on VIX and More

Tuesday, May 15, 2012

Cheating with Partial Hedges

[The following first appeared in the May 2011 edition of Expiring Monthly: The Option Traders Journal. I thought I would share it because of the strong positive feedback I received as well as the large number of questions I have recently fielded about hedges.]

After more than two years of a surging bull market that has seen the major stock market indices more than double, it is not surprising that many investors are becoming more concerned about protecting existing profits than finding ways to increase existing account balances.

As someone who makes a living trading options, you would think that finding a way to hedge my portfolio using options ought to be second nature by now. In fact, I have always placed more emphasis on offense than defense, not because I underestimate the importance of risk management, but because I generally find the opportunity cost of portfolio protection to be too high. I am sure this will sound like heresy to some, but the truth is that I never want to pay the full price for portfolio protection, so my efforts at hedging my portfolio have always emphasized finding the narrowest possible hedge for my needs and limiting the cost of that hedge as much as possible. In a nutshell, my approach is to try to figure out where the best place is to cut the corners and shave the odds, without significantly increasing my exposure. An academic may refer to this as creating a bespoke or customized hedge. I prefer to think in lay terms of cheating the odds. With the above in mind, the balance of this article attempts to explain how I look at constructing custom partial hedges.

Three Approaches to Hedging

First off, I have little interest in a hedge that caps my upside potential. For this reason, I generally steer clear of collars, unless I am going on a vacation and have no intention of watching the markets.

I find the following three types of hedging strategies have the greatest appeal:

1) Disaster Protection Hedge – A hedge that only pays off after a specified drawdown threshold, say 10% or 20%, similar to an insurance contract with a large deductible

2) Gap Protection Hedge – Has all the features of a disaster protection hedge, but also includes a cap, with the result that the hedge pays off only in a specified range, such as from a 10% - 20% drawdown

3) Proportional Protection Hedge – Instead of using thresholds and caps, proportional protection provides insurance against losses for a fixed percentage of each dollar lost

The common theme in each of the above three hedging strategy approaches is that an investor chooses partial protection rather than full protection, based on an assessment of the extent to which he or she finds losses to be an acceptable risk and at what losses must be hedged in order to preserve trading capital.

In the description of the three types of hedges, I have adopted some terminology normally associated with the insurance industry in order help clarify some important concepts. Specifically, I use the term deductible to describe the portion of a portfolio that is unhedged and thus 100% at risk. As Figure 1 below shows, in the case of a Disaster Protection Hedge, the deductible amount is equal to the first 20% of the losses that are unhedged, before the insurance threshold is triggered. In options parlance, the example in Figure 1 would be equivalent to holding a long position in SPY at 130 and having the position hedged with long SPY 104 puts, as 104 = 130 * 80%.

Figure 1:  Disaster Protection Hedges 80% of Portfolio with a 20% Deductible Before Insurance Kicks In (source: VIX and More)

While every investor should think long and hard about being hedged against a disastrous fall in stocks, such as the experience in 2008, in reality a 100-year flood does not happen very often and can be an expensive hedge to maintain on a daily basis. For this reason, I like the idea of what I call a Gap Protection Hedge. As shown in Figure 2 below, an investor might think that it is unlikely stocks will decline 20% or more, so he or she might prefer to remain unprotected for a 10% drop (i.e., a 10% deductible), yet be hedged dollar for dollar for any loss from 10% up to 20%. The maximum benefit of this hedge is capped at 20%, so once losses begin to exceed 20%, the investor is fully exposed to any incremental losses. In the options world, this type of protection would be similar to holding a long position in SPY at 130, with a hedge consisting of long SPY 117 puts and an equal amount of short SPY 104 puts.

Figure 2:  Gap Protection Hedges Only for a Specified Range, Here from 10% to 20% (10% Deductible, 20% Cap) (source: VIX and More)

While I find it helpful to think about hedged in terms of deductible thresholds and maximum benefits caps, proportional protection has the benefit of simplicity. In insurance terms, this is similar in some respects to a co-pay. As illustrated in Figure 3 below, there is no deductible or cap with proportional protection and the insurance coverage begins with the first dollar lost. This example shows how 50% proportional protection looks in graphical form. Here a 20% drop in the stock market only translates into a 10% loss due to the partial offset of the hedge. In the example below, the options equivalent for this strategy would be a position of 1000 shares of SPY that are hedged by 5 at-the-money puts. Of course, as the contract multiplier for SPY options is 100 shares, one can fully hedge 1000 shares with 10 puts, meaning that 5 puts would represent a 50% hedge.

Figure 3:  Proportional Protection Begins Immediately, But Only Covers a Percentage of Losses (Think 50% Co-Pay) (source: VIX and More)

Combining Multiple Hedging Approaches

While some investors might be happy sticking to one of the three type of partial hedging strategies mentioned above, the real fun begins when you consider these hedges as building blocks which allow an investor to design custom hedges.

For example, let us assume one is comfortable with accepting the first 10% drawdown as a cost of doing business and is willing to remain unhedged for the first 10% of portfolio losses. At some point, an investor will likely want a hedge to begin to offset some portion of incremental losses, yet might still think protection is too expensive to warrant being fully covered at a pullback of 10% or 20%. This investor might also think that stocks are unlikely to fall more than 30%, yet may not want his or her portfolio to suffer losses in excess of 20%.

One way to structure a hedge that meets all these requirements would be to buy gap protection for stock market losses from 10% to 20%, have proportional protection of 50% to cover losses from 20% to 30% and rely on disaster insurance in the event losses exceed 30%. Here the total maximum loss is 20% (the first 10% and 50% of the next 20%) and the hedge is structured in such a way that the investor pays nothing for the most expensive insurance (the first 10%), gets a discount on the next most expensive insurance (the proportional insurance for the next 20%) and only pays full price for the most unlikely events, where the markets fall more than 30%.

Conclusion

There is no denying that hedges are very expensive, particularly for those who put more faith in their trading skills than their hedging skills. Like any high wire-act, however, successful traders need a safety net to allow them to perform complex and dangerous maneuvers.

Traders who are able to define their risk tolerance in terms of worst case scenarios and potential maximum drawdowns have many ways in which to structure hedges to limit their risk. This article highlights three different approaches to structuring partial hedges for the purpose of maximizing portfolio protection while minimizing the cost of these hedges as well as the magnitude of certain types of risk. By combining these different partial hedging strategies, traders can customize their risk exposure to match individual needs and ensure that appropriate hedges can be constructed in a manner that is as cost efficient as possible.

Related posts:

Disclosure(s): I am one of the founders and owners of Expiring Monthly

A Look at the Pullbacks of the 2009-2012 Bull Market

At various times over the past three years, I have been posting a table that I call the VIX and More 2009-12 SPX Peak to Trough Pullback Summary, the most recent version of which can be found in a March post, Putting the Current 2.6% SPX Pullback in Recent Historical Context .

This time around I thought it might be of more value to present the same data, which now includes 17 pullbacks over a the course of a 38-month period, in the form of a scatter plot, with the magnitude of the peak-to-trough drawdown on the y-axis (inverted) and the number of trading days from the peak to the trough on the x-axis.

In the graphic below, I have highlighted the current 6.6% pullback from the April 2nd high of SPX 1422 with a solid red diamond. This pullback now ranks as the 6th deepest in terms of peak-to-trough magnitude and 3rd longest in terms of peak-to-trough trading days. Interestingly, the 6.6% pullback over the course of 30 days is well below the (dotted black) linear trend line for the full data set; the trend line prediction for 30 days is in fact a 9.3% pullback, which I have plotted with a hollow red diamond.

For reference, I have also annotated the top two pullbacks during the past 38 months:

  1. 21.6% over 109 days from May to October 2011
  2. 17.1% over 48 days from April to July 2010

While both of the above pullbacks had multiple causes, the theme of Greek contagion fears was prominently featured in both pullbacks.

Whether the current pullback stops at SPX 1328 remains to be seen, but clearly it is a long way before anyone will be comfortable saying that the European sovereign debt crisis is contained.

Related posts:

[source(s): Yahoo]

Disclosure(s): none

Monday, May 14, 2012

Handicapping the Chances of Greece Dropping the Euro

Understanding all the moving parts in the European sovereign debt crisis can be a Herculean task, even for the most determined analyst. Heck, even hazarding a guess at what tomorrow’s crisis du jour will be is more than enough for most investors to grapple with.

In the case of Greece, with an ever-changing political party landscape and fickle voters who intend to distort that landscape even more, trying to assign probabilities to various scenarios and then divine the implications for Greece’s relationship with the euro is sufficiently daunting as to cause many an investor just to park their money in cash until the future begins to look a little less murky.

For some aspects of the euro zone fiasco, there are financial instruments and measures that can serve as a barometer of how bad things are now and are likely to become in the future. Credit default swaps are an excellent example, as is the VSTOXX equity volatility index, the euro volatility index (EVZ), sovereign debt yields, etc.

As far as the euro is concerned, the EVZ is relatively subdued at the moment. Over the course of its life (which began in November 2007), EVZ has typically traded at just a shade over half of the VIX, which is where it closed today. Still, while the VIX posted its highest close since January, EVZ was substantially higher during January, February and the beginning of March.

It is at times like this when I find myself paying more attention to the various Intrade prediction markets contracts. In the case of the euro, Intrade has three separate contracts based on the possibility that a euro zone member announces it will stop using the euro as its national currency. The three contracts have expiration dates of the end of 2012, 2013 and 2014 and currently indicate (see top graphic below) that the probability of any euro zone country announcing it will drop the euro is 37.5% by the end of 2012, 61% for the end of 2013 and 68% for the end of 2014.

In addition to the probabilities derived from the price of these prediction market contracts, the trend also bears watching. The bottom graphic shows trades in the 2012 contract. Much to my surprise, sentiment that Greece (or any other country) will exit the euro this year apparently peaked (for now, at least) yesterday afternoon, and pulled back somewhat today, in choppy trading. For those who wish to watch this contract on a tick by tick basis, try the Advanced Charts option and click the Time and Sales radio button. Note that it is also possible to set alerts for this contract.

This seems like a good place to reiterate that I believe Intrade contracts, while helpful, are far from perfect. Still, if your talents do not include four dimensional euro zone dominoes in Greek, these prediction contracts can be a great shorthand for determining how certain events are likely to play out.

Related posts:

[source(s): Intrade.com]

Disclosure(s): none

Thursday, May 10, 2012

Looks Like Apple VIX (VXAPL) Futures Are Coming Soon

In case anyone missed it, I wanted to highlight a report yesterday from Reuters which quoted  Edward Tilly, President of CBOE Holdings, as saying that not only is the VIX product line ripe for expansion, but:

“We have benchmarks on a number of other products. I would point out one that is a favorite of mine that I wouldn't be surprised if I saw us launch in the near future - futures on Apple VIX.”

The Apple VIX (VXAPL) was launched in January 2011 along with similar single stock volatility indices for the following:

  • Amazon (AMZN): volatility ticker: VXAZN
  • Google (GOOG): volatility ticker: VXGOG
  • Goldman Sachs (GS): volatility ticker: VXGS
  • IBM (IBM): volatility ticker: VXIBM

A successful launch of futures on VXAPL might open the door for futures on one or more of the other single stock volatility indices above.

The chart below, courtesy of Livevol (StockCharts.com, you really should have VXAPL in your database) shows that VXAPL has tended to remain in the mid-30s, but has ranged between the high teens to the high 50s in the first 17 months of its life.

Recall that the CBOE Futures Exchange (CFE) launched futures on the emerging markets volatility index (VXEEM) in December 2011 and followed up by launching options on VXEEM at the end of January. The CFE also launched futures based on VXEWZ (CBOE Brazil ETF Volatility Index, which is based on EWZ) on February 21 and added options to VXEWZ on March 6.

If you enjoy trading volatility products, it looks like we may be entering the golden era of shrink-wrapped volatility indices, which can serve as a product platform for futures, options and even exchange-traded products. If you think VIX-based ETPs are fun, just wait until a VXAPL-based ETP is rolled out. Of course, if there is not enough demand for the futures and options, some of these ETPs may never see the light of day, so early adopters, don’t shy about hitting some of those bids.

Finally, on a somewhat tangential note, I think I received more emails on The Case for Selling Apple Puts than on any other post in the history of VIX and More. To all those who wrote, including those who elected to sell Apple (AAPL) puts, the current environment may be suitable for a revisiting this trading strategy.

Related posts:

[source(s): LivevolPro.com]

Disclosure(s): long AAPL at time of writing; Livevol and the CBOE are advertisers on VIX and More

Sunday, May 6, 2012

The Hollande Discount

With a little more than an hour to go before the equity markets open in Europe, investors are still attempting to digest the significance of an electoral victory for Francois Hollande in France as well as a much more fragmented political scene in Greece, where the radical leftist Syriza party showed surprising strength.

While the outcome of the election in Greece was very difficult to handicap, the probability of a Hollande victory increased dramatically over the course of the last month or so.

The chart of the week below shows the likelihood of a Hollande victory as indicated by the Intrade election contract (solid black line in upper half of top chart) since the second week of November. At the same time support for Holland was growing, one can see that the expectations for a Hollande victory put pressure on France ETF, (EWQ). The bottom half of the top chart shows a ratio of the EWQ to the broader Europe ETF, VGK as a solid red line. This ratio has declined sharply in conjunction with Hollande’s increasing strength in the polls and has moved in the opposite direction of U.S. stocks (gray area chart) since the middle of March.

For some additional context, I have also included a bottom chart that captures the EWQ:VGK ratio and the SPY going back four years. Note that France was generally a source of relative strength in the euro zone through June 2011 and has struggled relative to its peer group for most of the past year.

Looking at the full set of charts, it is apparent that the markets have been pricing in the likely impact of a Hollande victory for the better part of a month. With U.S. equity futures down approximately 1% as I type this, my sense is that the Hollande discount has almost completely priced in, but the increased uncertainty in Greece is likely to roil the markets and put a jolt into volatility expectations for at least the next few weeks going forward.

Related posts:

[source(s): StockCharts.com, Intrade.com]

Disclosure(s): none

Thursday, May 3, 2012

Guest Columnist at The Striking Price for Barron’s: Why I Am Short Fear

Today I am a guest columnist for The Striking Price on behalf of Steven Sears at Barron’s, weighing in with Be Greedy While Others Are Fearful.

The Barron’s article is a quick summary of some of the reasons I am short fear. Essentially, I am short fear not because I have a Panglossian view of the world and am unconcerned about events in Spain, China, Iran and other global flash points, but rather because fear is almost always overpriced – and by a wide margin. Between the volatility risk premium and persistent negative roll yield, long VIX strategies generally face an uphill battle.

I spell out the details of my thinking in the Barron’s article, but readers can find some similar themes in the links below.

Related posts:

A full list of my Barron’s contributions:

[source(s): StockCharts.com]

Disclosure(s): short VXX at time of writing

Tuesday, May 1, 2012

An Aroon Stalemate for S&P 500 Index

While the bias in stocks for the past three years and two months has definitely been upward, the S&P 500 index (SPX) has struggled to remain above 1400 ever since making a post-2008 high of 1422 on April 2nd.

There are many ways to determine the strength of a trend and one that has a very strong following is the Average Directional Indicator (ADX), which was developed by Welles Wilder and first published in 1978 classic, New Concepts in Technical Trading Systems.

While the ADX has a great deal to recommend it, I am somewhat partial to another trend evaluation tool, the Aroon indicator, which was developed by Tushar Chande. The Aroon is actually two measures in one, an Aroon Up (green line in study below main chart) and an Aroon Down (red line). Essentially, the Aroon Up and Down lines measure the proximity of N-period highs and lows to the most recent trading period, on a 0-100 scale, with 100 indicating that the high or low for the period was made during the most recent trading day and 0 indicating that the high or low was made on the first day of the N-period window.

The default time frame for the Aroon indicator is usually represented as 25 periods, but in some charting software, the default is 14 periods. Since I tend to look at the investing world in months that average 21 trading days, the chart below uses my favored default Aroon setting of 21 days.

The chart shows the SPX over the course of the past year, with a strong uptrend (green line above 50 or 70) since the second week in December that has recently begun to show signs of fatigue on the part of the bulls as it has now been 20 days since that high of 1422. On the other hand, the red line shows that it has now been 15 days since the SPX made its 21-period low of 1357. In other words, the last three weeks have seen neither the high or the low of the 21-day lookback period, as the SPX has meandered in a 65-point range. The result is that both the green line and red line have dipped below 30, signaling the absence of any meaningful bullish or bearish momentum.

The Aroon indicator is effective as a trend-following tool partly because it usually waits for 1/3 to 1/2 of the lookback window to elapse before signaling a change in trend – which is generally represented by either the green or red line crossing the horizontal lines at 50 or 70.

As it looks now, if stocks were to continue to tread water for the next four days, Monday would likely signal an ascendant green line, but Friday’s employment report, the European Central Bank and other factors make it unlikely that stocks continue to trade in a narrow range for another week or so.

Related posts:

[source(s): StockCharts.com]

Disclosure(s): none

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