Put to Call Ratios and Volatility Predictions

Michael at MarketSci is out with another provocative post this morning. Focusing on the CBOE total put to call ratio (CPC) data history, he uncovers an interesting relationship between an elevated put to call ratio relative to the 50 day moving average and next day volatility in the S&P 500 index. In The Put-to-Call Ratio at Extreme Values, Michael draws the following conclusions:

“High and low put-to-call ratios…have done a pretty good job at predicting next-day volatility… High PCR levels indicate a bearish sentiment (high level of puts relative to calls purchased) and have been followed by a significant increase in volatility (+29.7%). Low PCR levels indicate a bullish sentiment and have been followed by a significant decrease in volatility (-17.3%).”

Looking at over a dozen years of data, MarketSci also concludes that the pattern has persisted over time but has been less pronounced over the course of the last two years (see chart for details).

I will leave the reader to ponder the implications of having a one day edge in predicting SPX volatility, but given how active SPX and SPY options are, there ought to be quite a few different ways to profit from this type of insight.

Linkapallooza

With the markets warming up to the idea of a trading range, this seems like a good time to pull back and look at some broader issues. Thanks to all the great blogs out there (281 Bloglines feeds, as of today), I have had a lot to ponder as of late. Some of the latest colon-enabled ideas:

• Dollar: 80 week SMA resistance looms (Bernie Schaeffer)
• UK housing market: is “standstill” optimistic? (Michael Shedlock)
• Southern California housing resales: foreclosures 43.6% of July total (Larry Nusbaum)
• SoCal housing unplugged: a graphical overview (Tim Iacono)
• Sequential Hong Kong GDP: 1.4% drop (Toro’s Running of the Bulls)
• Debt: no takers? (hat tip, Michael Shedlock)
• Global bond market: 8/19/08 snapshot (John Jansen)
• Maoxian: CMBS BBB- spread still widening
• Karl Denninger: CMBX graphic, with a healthy dose of editorial commentary
• Hedge funds: they struggled last month too (Macro Man)
• Hedge fund model: coming unwound? (Cassandra Does Tokyo)
• Sector beat rates: industrials lead the way (Bespoke Investment Group)
• Sectors international exposure: energy and financials at extremes (Paul Kedrosky)
• Strong sectors: one way to increase the odds of success (Pradeep Bonde)
• Sector ETFs: pair trading strategy examined (CXO Advisory Group)
• Level 3 assets: check these before playing a bounce in financials (Barry Ritholtz)
• Gold: does inventory matter? (Tim Iacono)
• Recession predictions: does anyone listen to the economists? (Bespoke Advisory Group)
• Falling oil: what are the economic consequences? (James Hamilton)
• Oil and equities: how correlated are they? (Jeff Pietsch)
• Mark Hulbert: insider buying is bullish
• Paul Kedrosky (and the Pythons) on volatility: low VIX = crucifixion; high VIX = stabbing
• Frugality: finally back in vogue? (Felix Salmon)
• Loss aversion: a six part series on prospect theory from Bruce Hong
• Exit strategies: the keystone of any investing system (Charles LeBeau)
• Solar update: sunlight + poison = food? (Scientific American)
• (en)Gadget alert: Kensington wireless USB docking station

The ETF Energy Troika

The ETF revolution is making it much easier than ever before to draw comparisons across related groups of stocks and commodities.

In the past, it has been easy to compare and contrast the price action in crude oil and natural gas. With the advent of a coal ETF (KOL), now it is easy to lump coal into the same comparison.

The chart below shows the crude oil (USO) and natural gas (UNG) commodity ETF as well as the recently launched coal ETF, which is based on a basket of coal stocks (top holdings are BTU, CNX, and ACI). This comparison may have an element of apples to pears about it, but the correlation across energy sources is unmistakable. Note that all three ETFs peaked at the beginning of July and have fallen sharply for the last month and a half. KOL seems to be the best candidate to find a bottom first, with USO showing some signs of flattening out and UNG still heading lower. KOL was the first of the three ETFs to top in June and July; could it be the first to signal a bottoming energy market in August?

Blogroll Additions and Other VIX and More Changes

When I first started this blog, the reason was as much to create my own personal investment portal as anything else. As such, I have always spent a lot of time trying to shoehorn the best of a broad range of perspectives into my blogroll (“Blogs I Frequent”). Now that I have long since transitioned to subscribing to feeds, I do not keep the VIX and More blogroll as up to date as it should be. Recently I have pruned some blogs that appear to be inactive and have added several others that I can highly recommend:

• MarketSci
  
  
• Market Rewind
  
  
• Bull Bear Trader

In addition to the blogroll changes, I now have a total of four posts in a new section I have titled “VIX – Educational Posts”. See the upper right hand corner of the blog for more details. In the next week or so, I intend to add some new posts about implied volatility and historical volatility.

Also in the right hand column, I have added new section I am calling “Aggregator Communities Featuring VIX and More”. These sites republish some of what appears on this blog, but more importantly they do an excellent editorial job of culling what they consider to be some of the best posts from the top bloggers out there. I am pleased to be a regular contributor to each of these communities and encourage readers to test drive these sites.

Going forward, I have given some thought to how this blog might continue to evolve, including more of a global perspective, an emphasis on asset classes other than equities, increased commentary on macroeconomic issues and current events, etc. If readers have any suggestions about what they would like to see more of, this would be a good place to leave a comment.

The Dollar Is UUP

I know there are many stock pickers out there who never thought they would put on commodity positions until a spate of commodity-related ETFs began appearing. Perhaps the next frontier for these former “equities only” investors is currencies.

Clearly currencies aren’t for everyone and in some respects they are the ultimate zero-sum game, but if anyone doubted their importance, just look how the markets have changed since the dollar reversed its course and started moving up a month ago.

The chart below shows the UUP ETF, the dollar ETF whose formal name is the PowerShares DB US Dollar Bullish Fund. This ETF is based on the Deutsche Bank Long US Dollar Index Futures Index, where futures contracts are designed to replicate the performance of being long or short the US Dollar against the Euro, Japanese Yen, British Pound, Canadian Dollar, Swedish Krona and Swiss Franc. For more details, a good place to start is the UUP fact sheet.

It is important to note that while the dollar has made a substantial move over the course of the past month and is now breaking out of a three year downward channel, the dollar’s move is more the result of increasing concerns about foreign economies than it is about strength in the U.S. economy. The bottom line: the U.S. economic outlook has not improved over the past month; instead, things have taken on an even gloomier tone overseas.

Finally, I would be remiss in not pointing out that on balance, U.S. equities tend to react favorably to a rising dollar. The chart of the UUP shows the dollar’s rally off of the July low buffeting the S&P 500 index.

The Return of David Altig and Macroblog

I was very much disappointed when David Altig decided to suspend posting at Macroblog. The good news is that Macroblog is back and the more interesting news is that Altig is now Senior Vice President and Director of Desearch at the Federal Reserve Bank of Atlanta.

Altig describes the new role of Macroblog as follows:

“I originally launched macroblog in 2004 as an independent blog, but it will now be run through the Atlanta Fed on our Web site. Macroblog will feature commentary by me as well as other members of the Bank’s research department. The purpose of the blog is to help inform readers with commentary and observations on a variety of current economic topics, including monetary policy, macroeconomic developments, financial issues, and Southeast regional trends. I do need to emphasize that the views expressed in macroblog will not necessarily be those of the Atlanta Fed or the Federal Reserve System – feel free to quote me on that.”

His first policy-related post under the Atlanta FRB mantle is out today, with the title What the Fed Did During Macroblog’s Vacation.

If it isn’t already, be sure to put Macroblog on your required reading list.

Welcome back to the blogosphere, David.

Queuing Theory and the Price of Oil

I thought I might write something provocative and different this morning, yet I was surprised – and pleased – to see that Kurt Cobb of Resource Insights beat me to the punch by several days. In Sunday’s Does Queuing Theory Explain Oil’s Wild Price Swings? Cobb draws upon queuing theory as a possible explanation for price swings that seem to be out of proportion to changes in supply and demand.

Up front I should say that the extent of my knowledge about queuing theory is limited to some brief exposure to the subject back in business school. Still, that exposure made a significant impression on me, as one of the important takeaways was that a very small and seemingly insignificant change can quickly move a system from equilibrium to chaos.

Consider a grocery store that has ten checkers and only one or two people in each line. If one checker takes a 10 minute break, you would not expect that lines in the other nine lines would triple or quadruple in just a few minutes, but according to queuing theory, this scenario is quite likely. Similarly, if customers are entering the store at a rate of one every 15 seconds, it doesn’t sound like a change in the rate to one customer every 14 seconds could impact lines to the degree that they go from two deep to ten deep before the 10 minute break is over, but once again, this is a plausible scenario.

The mathematics of queuing theory (which I have no desire to delve into) explain how very small changes at the margin (i.e., number of checkers, average checkout time, customer arrival rate, etc.) can quickly move a system from equilibrium to bottleneck, with resulting wait times increasing exponentially. It may be a little bit of a stretch to say that a grocery store is analogous to the world oil market, but I do think queuing theory provides a model for how small changes in input and output rates can create a massive bottleneck problem in a very short period of time.

Sports, Emotions and Trading

When I wake up each morning, I take a drink from the blogosphere news fire hose in order to get caught up with what is going on in the world and to get a sense of how some learned minds are thinking about these and other developments. I find this process puts a lot of random ideas in front of me in a short period of time and often leads to some interesting juxtapositions that help stimulate my own thinking.

This morning had just one of those juxtapositions. First, in Olympics and Stocks Don’t Mix, Mark Hulbert cites the work of Edmans, Garcia, and Norli (“Sports Sentiment and Stock Returns”) which shows how World Cup soccer losses translate into significantly poorer performance in the local stock market the next day.

Hulbert weaves this research into his own observation:

“In my experience, few investors even recognize the role that their emotions play in their decision-making. When challenged, they are able to point to a litany of reasons, all well documented, for why their strategy is strongly based on a sound statistical foundation. But, most of the time, I still don't believe them.

That's because there are different types of reasons. On the one hand, there are the reasons that genuinely account for why we have decided to do something. And, on the other hand, there are the reasons that we turn to, after a decision has been made, to justify it to ourselves and others. Most of the investment reasons that I hear or read about are of the latter variety.“

Right after Mark Hulbert, I stumbled onto Brett Steenbarger’s A Dozen Thoughts on Trading Stress and Emotion. Frankly, I don’t recall ever having seen a short list that has so much for traders to chew on in the realm of “Know Thyself.”

There are many ways to look at the markets and how you interact with them, but one should never underestimate the emotional component on both sides of that equation.

Crude Oil Volatility Slides with Crude Prices

Based on the large number of Google searches that have recently been landing on the blog, there is considerable interest in the CBOE’s new “Oil VIX” or crude oil volatility index (ticker OVX), which was launched exactly four weeks ago today.

While it is still too early to pluck much in the way of useful conclusions from the OVX, I have included a chart of the new volatility index below. So far what may surprise most newcomers to crude oil volatility is that the OVX has fallen in concert with crude oil prices (as measured by the USO crude oil ETF). My analysis of USO options suggests that crude oil implied volatility and the price of the underlying are likely to be largely uncorrelated going forward, which is in sharp contrast to the strong negative correlation between equities and their corresponding volatility indices, such as the VIX, the VXN, and the RVX.

An Eight Year View of the Dollar

Last week’s 3.3% gain in the dollar was the biggest weekly gain since the dollar peaked some seven years ago.

The chart below chronicles the decline in the dollar over the course of two long downward legs, the first leg running from 2001-2004 and the most recent leg from the end of 2005 to the present.

From a technical perspective, it is still too early to say that the dollar has begun a decisive new uptrend. Since 2001, there have been quite a few 3-4 month countertrend rallies and one full year (2005) in which the dollar looked to be making a new bullish leg before reverting back to the long-term downtrend.

That being said, the dollar is nearing the top of its trading channel for the first time in over a year. Looking at macroeconomic and other factors, I believe that a channel breakout is the most likely scenario, which will bring a new technical twist to currencies, commodities, bonds and equities.

Monday Musings From Around the Blogosphere

I stayed up late to watch the men’s 4x100 freestyle relay and it was well worth losing some sleep to see that amazing anchor leg by Jason Lezak.

In any event, I am fortunate that other bloggers have been out there digging up some nuggets to keep my brain engaged...

• David Merkel discusses The Fundamentals of Market Bottoms
• Eric Roseman is skeptical of a bottom in Stock Market Rally Since July 15 Not Confirmed by LIBOR or Mortgage Rates
• A South Ossetia primer from Jesse’s Café Américain in The Fog of War Descends on the Oil Rich Caucausus
  
• David Enke details The Cost of Low Interest Rates
• Tom Drake checks in with a visual overview of the current environment in Media Blather Versus Reality: Wordless Economics
• James Hamilton is in top form again in Oil and the Dollar
• Michael Shedlock looks ahead in The Future Is Frugality
• Nouriel Roubini’s latest: The Perfect Storm of a Global Recession
• Jeff Pietsch has a new installment in his series superb weekly (and monthly) summary graphics: Market Rewind – Week 32 (08/08/08)
• Barry Ritholtz has some Lessons Learned from a Dangerous Year
• James Picerno is Ranting About Risk (Again)
  
• MontyHigh looks at Gold Fundamentals: Central Bank Selling
• Marc Eckelberry braves a VXN Outlook
• Michael Stokes compares Market Volatility in Up vs Down Trends
  
• Jeff Masters has an August Sea Surface Temperature Outlook that is bullish for warm water and tropical storm activity
• A similar theme was struck by Joseph Dancy, who interprets some of the July tropical storm data and opines on the implications for the current month in Hurricanes May Blow Energy Sector Off Course

Increasing Options Volume in Double Inverse ETFs Crowding Out VIX Options?

One year ago this month, VIX options peaked in popularity. As the graphic below from IVolatility.com shows, VIX options continue to trade at impressive volumes of about 100,000 contracts per day, but this number is about 30% below the levels from August-November of last year.

Part of the reason for this change in trading patterns is that some of the portfolio hedging trades formerly conducted with VIX options are now being redirected to options on double inverse ETFs. Back in February, in Interest in VIX Waning? I spoke about how the new trend seemed to favor QID options over VIX options. Six months later, the popularity of QID and SDS options persists, with QID + SDS options now accounting for approximately one third of the volume in VIX options.

More recently, the rise of double inverse sector ETF options has translated into more choices for investors and lower market share for the VIX. While sector options are more likely than VIX options to be used for speculative purposes than as portfolio hedges, the surge in options volume for double inverse sector ETFs is worth highlighting here, with the SKF (double inverse sector ETF for financials) and DUG (double inverse sector ETF for oil and gas) receiving the most interest.

The rise of inverse and double inverse ETFs raises a number of questions about the VIX and poses some challenges for the index as a portfolio hedging tool and as a sentiment indicator. I will delve into these two subjects in more detail in the coming weeks and months.

Weak Bounce in Homebuilders

Pending home sales are up 5.3% today, handily beating the consensus expectations, which called for a 1.0% decline. Barry Ritholtz at The Big Picture has a different interpretation of the data in Media Gets Pending Home Sales Wrong (Again!) Not surprisingly, Barry is less optimistic about the state of the housing market and emphasizes the importance of looking at year over year changes instead of sequential monthly changes.

The homebuilders are a very interesting sector – and one worth following closely. Homebuilder stocks (as measured by the XHB ETF) actually peaked at 39.39 back in early February 2007, several months prior to the time frame covered in the chart below.

For a few months, homebuilders looked as if they had made a bottom in January, when they rallied more than 60% from their January low to their April high, only to grind down to a new bottom in July. The graphic shows a sharp two day bounce off of the July low, followed by a lot of sideways action over the course of the past three weeks. At this stage, the July bottom does not yet look convincing and XHB is actually trading down as I type this.

With foreclosure activity now accounting for an increasingly large percentage of all home sales, statistics such as selling price per square foot (see Solano County, in particular) may help to sort out some of the divergence between sales volume and sales price data.