Coming Soon…

There are really only four places where I can consistently brainstorm at the top of my game (a free VIX factoid for anyone who can guess all four of them) and one of them is on long airplane rides.

Since swapping the nomadic consulting lifestyle for that of the geographically constricted stay-at-home trader/investor, I sometimes find myself missing those six hour coast-to-coast flights where I could point my brainwaves in a particular direction and free associate without fear of interruption. Yesterday I had one of those rare opportunities for brainstorming at 38,000 feet and from that session comes a number of ideas that I will likely be talking about in this space in the next two or three months.

Among the subjects that I will be taking a closer look at, in no particular order:

• Looking at volatility across the full range of asset classes (not just US equities)
• Long-term volatility forecasting
• Diving deeper on the correlation between the SPX and the VIX (short-term and long-term)
• Non-VIX volatility measures for the SPX/SPY (ATR, Bollinger Band width, etc.)
• VIX implied volatility vs. historical volatility
• With hurricane season upon us, it is time to look at hurricane-related volatility in drillers, refiners and oil services companies. What are the investment opportunities? How do they mirror the VIX?
• Revisiting the idea of a VIXdex
• How to parse the universe of volatility events -- and maybe flesh out my ideas on a "taxonomy of fear"
  
• Is there a fat tails inflection point? Is there an options tipping point where mean reversion battles new money?
• Fear vs. volatility: Is it meaningful to talk about these subjects separately?
• Develop a Long Term Capital Management timeline superimposed on the VIX

If readers have any particular areas of interest they would like to see me elaborate on, just note them in the “Comments” section below and I’m sure that some of them will get thrown into my R&D queue. Also, if readers have pointers to some interesting work already done in some of my target areas of interest, I would love to hear about these as well.

Bird Flu Stocks and Volatility

Confirmation of bird flu at a UK turkey farm over the weekend put bird flu stocks back in the spotlight once again. Over the past two years, most of us have become largely desensitized to the possibility of a widespread bird flu outbreak, as each incident has spawned a less and less strident media frenzy. In a sense, the same soft of desensitization has set in over the past year or two with bird flu, terrorism, $100/bbl. oil, Iraq/Iran, North Korea, etc. The media has a field day for awhile, but as the panic level subsides for a second or third time, the public sees these as more cry wolf exercises and makes a mental note to ignore future scare tactics and, in many cases, completely tune out the entire issue.

Is this why the VIX has now made 33 consecutive new lows for the 100 day SMA? Perhaps it is not so much complacency that has set in as mass desensitization.

Back to bird flu stocks. Their price movement has a strong fear component in them and as such, they are part of the VIX taxonomy of fear (which I will someday formalize as the VIXdex.) It should come as no surprise, then, that bird flu stocks have characteristics that are similar to that of the VIX. Specifically, they tend to spike up sharply, then subside over time, with patterns of 1 and 3-5 day spikes being relatively common. Some of this can be seen in the BCRX daily chart, where the Williams %R and CCI are showing that four days into the move up, we have a good shorting opportunity:

NVAX, AVII and GNBT are among my favorite of the pure play bird flu vaccine makers. If you have tested systems for trading the VIX, consider that the same tactics may work as well or better with bird flu stocks, with an opportunity to trade the underlying and with lower implied volatility for the options:

On the Nature of Fear

Fear is a strange animal. It is easy to unleash, yet hard to put back in a cage. It spikes up, but rather than spiking down, it tends to slowly subside over time.

Why is this the case?

In the stock market, there are many factors that may spook investors. In the future I am considering trying to construct a formal Taxonomy of Fear, but for now, let me offer some examples. In the global political arena there are fears that range from terrorism, nuclear proliferation, Middle East tension, and a war in Iraq that could spiral out of control, to the spread of socialism in South America, China playing hardball with the renminbi, Russia throwing their weight around with energy and natural resources, etc. On the macroenomic front, is it inflation or deflation we should be more concerned about? Throw in the possibility of a recession, productivity declines and a hiccough in the job creation engine and there is the potential for a stagflation stew. Really want to make it nasty? Add a dollop of bird flu or SARS on the health front, sprinkle in some peak oil talk and the possibility of another large hedge fund or two imploding and you can see how emotionally charged the investment horizon can appear.

These are not one day events, either. These are the types of issues that grab headlines day after day after day. Whether or not the reality of the situation is worsening, play in the media will manage to keep these issues in the headlines and top of mind for the investment community – and with it, a sense of fear.

Very few of these fears can be defused overnight. The geopolitical issues, in particular, tend to persist for decades, with relative visibility ebbing and flowing over time. For the most part, economic fears and health fears are not going to be quelled in the short-term either. At best, they may come and go in cycles and even if they do fall off of our radar, new concerns are likely to bubble up to take their place.

Ultimately, fear spikes, often instantaneously, and leaves an emotional imprint. If too many unsettling events -- or even one event of seismic proportions -- result in the piercing of the comfort threshold of the average investor, then echoes start to show on the tape and fear cannot be put back in the cage.

The data make this clear. The VIX, which in some respects resembles fear, is seven times more likely to spike up three standard deviations in one day than to spike down; it is fifty times more likely to trade three standard deviations above its 10 day moving average than below it. Asymmetrical VIX spikes are not just an issue of frequency, but one of degree too. On the 26 days that the S&P500 has fallen by 3% or more in a single day, the VIX has spiked up an average of 16.8%. Conversely, on the 33 days in which the S&P has risen 3% or more, the VIX has fallen only 9.2% on average.

In most instances, an investor would have been well served to bet on these VIX spikes reverting to the mean within a week or so, but a better understanding of the taxonomy of fear and of important fear thresholds is critical to assessing when to fade the trend and when to ride it.