- Larry McMillan in Barron's makes the case for why VIX options may offer better portfolio insurance than SPX options
- David Gordon of the Deipnosophist puts some of the recent credit spread issues in historical context
- David Kneupper of the dk Report elaborates on the predictive power of the IBD100
- CH Tan at Cougar Jump captures the 12 stocks that salmoned upstream on three consecutive days last Wednesday, Thursday and Friday, with increased volume
- From Options Doggy comes the CEO quote of the month, on the lure of retirement
- The Lauriston Letter outlines a trading strategy which combines the VIX and put to call ratios (two of my two favorite indicators)
- Jeff Kohler of Option Addict has four reasons not to trade VIX options (I generally agree with his thinking here)
- Eddy Elfenbein of Crossing Wall Street unveils the magic of bullish Wednesdays
- Brett Steenbarger at TraderFeed highlights his favorite articles and much more (bookmark this one!)
- Simply Options Trading has a list of some sector rotation resources
- Bespoke Investment Group studies net analyst upgrades and downgrades to see if they can predict market direction (it appears they cannot)…and talks about why earnings guidance may not matter
- Corey at Afraid to Trade has some insight into the technical damage caused by earnings misses
- The CXO Advisory Group offers tepid support to moving average crossover systems
- I.L. at musings of a trader flags research showing the validity of the head and shoulders pattern
- Bill Gross of PIMCO talks about the implications of the rising cost of financing and other issues in his August 2007 outlook
- James Hamilton of Econbrowser examines how relevant OPEC is
- Chris Geerlings in Financial Sense outlines four scenarios for US oil reserves
- Chris Perruna notes a divergence between oil stocks and the commodity
- Barry Ritholtz at The Big Picture looks at the divergence between oil and natural gas
- Pradeep Bonde at Stockbee examines two short selling strategies from Mark Boucher
- Brett Steenbarger at TraderFeed offers some thoughts on anticipating stock market volatility…researches what happens after markets gap down and gap up…and talks about opening range breakouts
- David Merkel at The Aleph Blog has 25 ways to reduce portfolio risk
- Macro Man has an excellent overview of Chinese Trade
- …and David Altig at macroblog thinks that it will be longer than most expect before the Chinese economy fulfills our collective expectations
- Mebane Faber of World Beta discusses a new $25 billion managed futures fund
- David Merkel is at it again, this time tinkering with the Fed Model
- From the what’s-in-a-name department comes the CXO Advisory Group’s study of the successful Decision Moose asset allocation framework
- Tom Lydon at ETF Trends suggests a closer look at a new asset class: foreign real estate ETFs
- Maoxian offers up an indirect comparison of the brain of an undergraduate and someone about to get an MBA
- Stephen Leavitt of the Freakonomics Blog shines some much needed light on in-flight ‘news’ programs offered by airlines
- Barry Ritholtz at The Big Picture has some ideas on when to buy low…for items other than stocks
- Uglychart has some suggestions on which fruits and vegetables should be organic only in your shopping cart
- Numeric Life has a warning out that obesity is contagious
- …and finally, Matt at Paleo-Future has a peek at my next vehicle
Tuesday, July 31, 2007
Links: Play it Where it Lies
The SPX:VIX Ratio, the Mean Reversion Magnet, and Fun With Numbers
During all the excitement of the past week, quite a few indicators printed extreme readings. One that was all over the press was the surge in new lows. Babak, Dr. Brett and Headline Charts did such an excellent job of covering this one that it hardly seems worth noting again here.
Another indicator to print extreme readings that I’m sure I follow much more closely than others is the ratio of the SPX to the VIX. I’ve written a fair amount about the SPX:VIX ratio in the past and am of the opinion that the 10% trend line (for an explanation of the 10% trend line, try “The SPX:VIX Relationship”) acts as an intermediate to long-term mean reversion magnet.
One interesting aspect of the ratio is that it does not specify which of the variables will mostly likely be responsible for moving the ratio back toward the historical trend line. Given that the VIX is much more volatile than the SPX, it is natural to assume that the VIX will make the sharper move, so with an SPX of approximately 1500 and a SPX:VIX ratio of 115 or so, this implies a VIX of 13.04. One interpretation of this calculation is that the VIX is approximately 50% ‘too high’ for the current level of the SPX. Of course, another possible interpretation is that the VIX has been ‘too low’ for much of the baseline period.
Another way of looking at the ratio is to fix both the ratio and the VIX and solve for the SPX. Assuming a VIX in the neighborhood of the current 20 value and a SPX:VIX ratio of 115, this projects to an SPX of 2300, which stretches the limits of credibility a little too far for my taste.
So…if you believe in a relatively constant long-term relationship between the VIX and a trending SPX and all the assumptions that go along with it, which of the two scenarios is more likely to bring the SPX and VIX back toward an equilibrium: an SPX of 2300 or a VIX of 13?
For the record, I do believe in the trend line magnet properties of the SPX:VIX ratio, but I am quick to note that the mean reversion magnet sometimes exerts a sufficiently weak influence that the ratio can stay out of balance for several months to at least two years, as was the case during 2002-03. As unlikely as it may seem in the context of continued volatility in today’s session, the odds favor the SPX:VIX ratio being back in the 100-120 range in the next two months – and this sets up a number of potentially interesting trades.
Monday, July 30, 2007
RUT Hedge Fund Puke?
On the off chance that there are readers out there who have not bothered to read Bernie Schaeffer’s market commentary because it requires a free registration to Schaeffer’s Research, you really should rethink that idea. Take, for instance, Schaffer’s “Monday Morning Outlook: Fear Swells Amid Market Pullback,” which was published earlier this morning. Here Schaeffer pulls a gem from Stonebrook Structured Products, a provider of hedge fund replication strategies:
“A large part of hedge fund returns are driven by shorting large-cap growth and the going long small-cap value and emerging market equity. True alpha accounts for only 20-25% of industry returns.”
Schaeffer extends this idea to come up with a hypothesis for the recent substantial performance gap for small caps (as evidenced by the Russell 2000 falling almost three times as hard as the large cap indices):
“Once the more volatile smaller-cap stocks began to seriously under perform the S&P, their short S&P hedges were not sufficiently protecting them (which caused them to be ‘too long’ in a market correction) and the hedge funds then needed to go out and sell stock from their portfolios and/or short the IWM or buy IWM puts. And all of this served to further blast the IWM.”
Interestingly, a look at the volatility of the Russell 2000 index (RVX) compared to the VIX does not reveal the underlying dynamic that Schaeffer suggested, but a study of the ratio of the IWM to the SPY does support his contention. See the two charts below for a better sense of this.
One key takeaway from this exercise is that some important volatility-related information is flying under the radar of the volatility indices. Another key takeaway is that ETFs are not only the driving the force in the markets these days, but they need to be a central part of any market technician’s analytical toolbox as well.
Hedging Volatility with CME
After a week of market turmoil, I noticed that Barron's is now making a similar recommendation, Business Week has described "a sea change in the way trading is done," and an AP story confirmed an ever growing bandwagon last Friday, when CME closed with an impressive 19.00 gain.
Even if volatility settles back into the mid-teens, I still think CME is a strong play, with the most recent quarterly results supporting that idea. If, however, the VIX continues with a 20 handle past Labor Day, then I suspect CME could be a much bigger winner than many on the current bandwagon expect.
Of course, regular readers will be quick to recall that predicting volatility one month out can be a humbling experience...
Sunday, July 29, 2007
Portfolio A1 Last Seen in Woodshed
While the SPX, DJIA and NASDAQ Composite all feel somewhere in the 4.0 - 4.7% range during the past week, Portfolio A1 plummeted 9.2%, dragging the portfolio’s aggregate performance down below that of the benchmark S&P 500 index for the first time in four months.
Southern Copper (PCU) was the only holding to fare better than the indices, losing 3.3% on the week. The next ‘best’ performers, Mobile TeleSystems OJSC (MBT) and Terex (TEX), fell 7.7% and 8.6 respectively. Two other holdings logged double digit losses on the week, with Amkor (AMKR) off 11.9% and Pinnacle Airlines (PNCL) plummeting 13.6% by Friday’s closing bell. Pinnacle’s performance is largely responsible for it being dropped from the portfolio and replaced by Navistar International (NAVZ), a stock I owned some 23 years ago when it was International Harvester. While the company has had some extremely difficult challenges in the intervening years, a recent $623 million contract award to the military vehicles division suggests considerable upside potential. Navistar lost only 1.0% last week and has the potential for a significant upside surprise in more favorable market conditions.
There are no other changes to the portfolio for the coming week.
A snapshot of the portfolio is as follows:
Saturday, July 28, 2007
VIX Spikes to 24.17, VWSI at -10
Thanks to an unusual 1.20 surge from 4:00 – 4:15, the VIX managed to spike all the way up to a 24.17 close on Friday, ending the week up 7.22 or 42.6%. In dollars and percentage terms, this is the type of VIX weekly move that you would expect to see only a couple of time per decade, yet this week’s action does not quite match that of five months ago, when the VIX jumped 7.99 points on a much smaller base and logged a 75.2% gain for the week.
Several readers have asked what these extreme VWSI readings mean. In a nutshell, they mean that a short-term (i.e., 5-10 trading days) VIX mean reversion move is highly likely and tradeable. While this also means that the broader markets will likely move in the opposite direction of a mean-reverting VIX, I tend to focus on the VIX play rather than the broader markets play – at least so far – in this blog.
In terms of historical context, I provided some interesting data for the week of February 27th that neatly predicted the subsequent unprecedented VIX contraction. I will expand upon this data set by offering up the only instances of an end of week VWSI of less than -6 since the shortened week of September 11, 2001:
- week ending 3/22/07: VWSI of -10…VIX -24.3% the next week
- week ending 5/19/06: VWSI of -9..…VIX -17.0% the next week
- week ending 1/20/06: VWSI of -7..…VIX -17.8% the next week
- week ending 4/15/05: VWSI of -9..…VIX -13.3% the next week
- week ending 9/21/01: VWSI of -8..…VIX -25.2% the next week
(Note that in the above temperature gauge, the "bullish" and "bearish" labels apply to the VIX, not to the broader markets, which are usually negatively correlated with the VIX.)
Wine pairing: What kind of wine should you drink when volatility spikes and skewers your portfolio? A fortified one, of course! I am specifically talking about port, a wine that Americans often fail to properly appreciate. Port is a complex wine with a complex story that requires more than this small space to tell properly. A good introduction can be found in “A Port Primer Ruby,” by Steve Pitcher. To save you some lengthy research, I suggest you just go ahead and sample something in the $15 range, preferably Fonseca Bin #27 and/or Graham’s Porto Six Grapes. If either of these is a hit, then you should probably sample the slightly more expensive 10 and 20 year tawny ports, keeping in mind the names of Taylor, Dow and Fonseca. As soon as we see another VWSI of -10, I will elaborate on port in considerably more detail. This who catch the port bug are encouraged to take a peek at For the Love of Port to help further your interest.
Friday, July 27, 2007
VIX Soaring in 4:00 - 4:15 Window
Well, at 4:00 ET the VIX was trading at 22.97, but it has jumped to 24.17 – another 52 week high – in the quarter hour since the final bell at the NYSE. My guess is that many had been playing for a bump rather than a plunge in the last half hour and are rethinking and/or hedging their positions going into the weekend during this 15 minute 'last call' window.
The Return of the Absolute VIX
Bloggers were all over the story of the dead VIX. Ron Sen at Technically Speaking noted the prevailing sentiment about a terminally ill VIX as far back as November 2005. Even after the February 27th VIX melt up, MissTrade declared that the VIX corpse was “still dead.”
Fast forward to the present and here we are with a VIX in the 20s and suddenly the old numbers may have some meaning. Now 15 looks like the new 10 and it makes sense to talk about the absolute levels of the VIX, not just the VIX numbers relative to some moving average of recent values. Not only that, but it is time to consider mean reversion in the context of a VIX with a lifetime mean of 18.94. In looking at the chart below, one of the first things you notice is that whenever the VIX lives below its lifetime mean (the dotted blue line), the SPX is in a bullish phase, but when the VIX rises above the lifetime mean, the odds of a SPX bull drop back to no more than 50-50.
I will have a lot more to say about the absolute level of the VIX in the future. For now, I mostly want to stretch the historical context of the VIX back to encompass the full 17 ½ years of VIX data.
Thursday, July 26, 2007
Some Data on Post-Spike Performance
You can follow the links below to get some historical context:
For what it's worth, I think today has been way overdone, but that doesn't necessarily mean the worst is over. I suspect it may take several weeks to get this one out of our system.
VIX 21.50 = Blood in the Streets
I am long equities and short the VIX, as we are at VWSI -10.
Today's VWSI of -10 Threshold is at 21.25
For what it's worth, I am starting to get short the VIX as it sits just below 21.
One Approach for Volatile Sideways Markets
I was being a little cheeky when I suggested that this index might be useful as a market timing tool. Instead, I figured that the best application of a buy-write strategy would likely be as a cash equivalent of sorts, particularly for those who were looking for a place to park their money somewhere that it could earn a reasonable return in a volatile sideways market, yet participate in any unexpected upward moves.
I think we may be in just that market environment right now.
If you are worried about the RUT falling through its 200 day SMA today and most of the other major indices penetrating their 50 day SMAs, then perhaps you should take a long look at the BEP, MCN and BWV. I am slightly partial to the BWV, because, as an ETN, it will not have (taxable) distributions. There has been very little volume in BWV in the two months it has traded, but with a typical bid-ask spread of 0.10, it is competitive with the more liquid BEP and MCN at least on a small scale.
Wednesday, July 25, 2007
Tuesday, July 24, 2007
VIX Has More Room to Run
Thanks in part to a strong earnings report from Amazon (AMZN), the VIX dropped back to 18.55 by the time of its 4:15 ET close, down from an intra-day high of 19.09.
How high will the VIX go from here?
Turning to the VWSI, I note that it closed at -3 today, indicating that there is still a fair amount of room for the VIX to run without getting overextended. For the VWSI to reach -6 tomorrow – the point at which I generally look to fade the move with options – the VIX will have to touch 19.26. Also consider that a VWSI of -8 requires that the VIX hit 19.46 tomorrow; the maximum reading of a VWSI of -10 would result from a VIX of 21.21. So, if it turns out that today’s 19.09 is not a near-term high in the VIX, I would expect to see the VIX topping out in the 19.50 – 21.50 range. (Note that all VWSI numbers are reset at the end of each day, so these thresholds are moving targets and will be lifted higher by a gradually trending VIX.)
One way to illustrate the moving target aspect of the VMSI is to look at the VIX’s somewhat analogous moving average envelopes. Shown below are the 10% (dotted green line) and 20% (dotted purple line) moving average envelopes that surround the VIX’s 10 SMA (solid blue line.) As the VIX has trended upward over the past three months, the moving average envelopes have risen with it, so while the 17.08 and 18.98 VIX spikes in early and late June look like breakouts that are highly susceptible to the gravitational pull of mean reversion, today’s runup to 19.09 looks much more like normal oscillation around an uptrending mean.
Of course the VIX should not be the only tool in your toolbox. When I look at put to call ratios, new highs and new lows, as well as other market sentiment data, the case for the VIX topping out soon looks fairly strong to me.
Earnings Spike Potential Algorithm v1.1
Never one to leave well enough alone, I have taken my CNBC Million Dollar Portfolio Challenge (remember that disaster?) cardboard and duct tape version of the ESPA and tweaked it a little for the current earnings season. The changes are not that major and consist largely of beefing up some TA inputs having to do with support and resistance. The resulting ESPA v1.1 seems to do a better job of predicting the magnitude of the post-earnings move and a noticeably better job of picking the direction of that move (which was previously just a little above 50%.)
Armed with a better mousetrap, I will be more active in earnings plays this quarter than usual, using the model to be both long and short straddles and strangles, as well as playing some instances where I have directional bias with straight calls/puts or call/put backspreads.
I do not intend to clutter up with space with a flood of predictions or comments on individual stocks, though I may highlight one or two from time to time. Still, looking at some of the earnings spiker candidates for AMC today through BMO tomorrow, I was struck by the sheer number of stocks with a very high short squeeze potential and a high implied volatility, two ingredients that can help turn a couple of sparks into a widespread conflagration.
Stepping back a little, my thinking is that most of the recent market action has been of the healthy correction variety – the controlled burn that renews instead of destroys. I also think that much of the bearish sentiment we find rolled into an 18ish VIX is of the bullish contrarian variety. As far as I can tell, the big fears are on the table and in the headlines. I suspect that it will require something new and unanticipated to give us the type of conflagration where we could see something like the VIX of 25-30 referenced by Jim Kingsland.
Monday, July 23, 2007
ISEE Update
I haven’t said much about the ISEE lately, largely because it hasn’t been saying much to me. In my last call, on April 23rd, I predicted the formation of a double bottom in the ISEE’s 50 day SMA; that turned out to be exactly what happened, and if you have been long the markets in the past three months you have likely done very well.
Today, Babak at Trader’s Narrative is forecasting a turbulent market ahead, saying that because of a jump in the ISEE’s 10 day SMA, “for the next few days and weeks, the market may be heading into some kind of a short term top or choppy trading.” He also offers up an excellent chart to support that prediction.
While Babak is consistently one of my favorite bloggers, I am going to have to take the other side of his prediction. First, I offer up my own chart of the ISEE’s 10 day SMA, along with the SPX, and take it back to the beginning the ISEE, almost five years ago. As the chart below shows, the current level of the ISEE 10 day SMA is just about in the middle of the 5 year range, with readings of 200 or so better suited for calling market tops than the current 157.
My preferred ISEE SMA, the 50 day variant, still shows a relatively low level of call activity (recall that the ISEE is a call to put ratio, not the more common inverse) going back all the way to last summer’s correction. As shown in the chart below, April’s buy signal is still intact and does not look to be threatened in the near future, even though ISEE readings have been drifting decidedly higher as of late.
For what it's worth, the put to call ratio that continues to concern me is the CBOE equity put to call ratio, but as I generally give precedence to the ISEE over the CBOE’s equity ratio, my concern is rather muted at this stage.
Sunday, July 22, 2007
Portfolio Adds PCU and PNCL, Drops ORH and PBR
In yet another reminder that this type of portfolio is not aimed at the buy and hold investor, Portfolio A1 has decided to drop Odyssey Re Holdings (ORH) and Petroleo Brasileiro (PBR) and replace them with high flying Southern Copper (PCU) and Pinnacle Airlines (PNCL), a regional airline whose traffic is up 11.2% so far this year.
Technical and fundamental factors were both in play for this particular portfolio reshuffling. It was the technical performance (down 8.7% in the four weeks it was in the portfolio) of Odyssey that was its undoing, while PBR suffered from a slight downtick in some fundamental metrics that more than offset a 6.2% gain in the two weeks it has been in the portfolio.
These two changes bump the annual turnover rate in this portfolio up to 415% and send us back to the drawing board to find three stocks that can match the performance and continued promise of stalwarts Terex (TEX) and Amkor Technology (AMKR).
There are no other changes to the portfolio for the coming week.
A snapshot of the portfolio is as follows:
VWSI at Zero, While VIX Rises to 16.95
With its 16.95 close this week, up 1.80 or 11.9%, the VIX is now perched on its highest end of week close since the week of February 27th.
The VWSI apparently does not believe that the VIX is unusually high, as the zero reading in the VWSI indicates a neutral bias for the next week or two, lending support to my contention earlier this week that “15.00 now looks suspiciously like a floor” in the VIX and “we are entering a new era of increasing volatility.”
Historians may wish to note that not since the middle of May 2004 has there been a VWSI of zero when the VIX stood at 16.95 or higher. During this period, India’s stock market had its worst drop in 129 years over concerns about the role of communists in a new government, oil prices rose over $40 for the first time in 13 years, conflict between Israelis and Palestinians was intensified, and Abu Ghraib was the headline story in the Iraq war.
Is 15 the new 10? In the coming week or two, I will delve into some possible repercussions of an elevated VIX. In the meantime, consider that from the current level, we no longer need such big percentage moves to see a VIX in the low to mid-20s.
(Note that in the above temperature gauge, the "bullish" and "bearish" labels apply to the VIX, not to the broader markets, which are usually negatively correlated with the VIX.)
Wine pairing: For an inexpensive Rhone blend, I continue to recommend: Oakley Five Reds; Robert Hall’s Rhone de Robles and Tablas Creek’s Cote de Tablas Blanc; Wrongo Dongo, the contrarian favorite from Spain; and The Stump Jump (I prefer the white over the red) from Australia. If you are looking for additional ideas, I encourage you check out the Rhone Rangers.
Friday, July 20, 2007
Volatility Aces Bloggers
Adam made a strong case for lots of dead time during the options cycle leading to lower volatility, perhaps as low as single digits. I took the easy way out and predicted that volatility was most likely to remain in the 12.50 – 15.00 range that it looked like it was settling in to at the time.
Well…if this were tennis, we would be talking something like 6-1, 6-0, 6-0, with volatility taking the two of us out in straight sets and sending Bud Collins (not pictured) officially into retirement. As the VIX chart below shows, volatility spent almost the entire options cycle in the 15.00 – 19.00 range, with the 15.00 resistance that I was counting on a month ago now looking like support. And this is the bigger story.
Nobody should be surprised that we whiffed on our volatility forecasts, as long-term volatility forecasting is extremely difficult. With an additional month of hindsight, however, 15.00 now looks suspiciously like a floor in this all-important volatility measure. If this turns out to be the case, then I can safely say we are entering a new era of increasing volatility. In fact, I think it is just about time to update the long-term VIX chart I offered up on my first post on this blog some 6 ½ months ago by adding a fifth macro period. Ironically, as it turns out, this new period of increasing volatility neatly coincides with the life of this blog. You don’t think…? Nah.
Thursday, July 19, 2007
Pssst. Wanna Make an Easy $800,000?
I mention Options Doggy in the context of $800,000 because earlier today, they reported a trade involving the sale of 20,000 VIX September 25 calls for 0.40. So it’s not exactly $800,000 after commissions, but it’s fairly close.
My first thought was that 0.40 seemed like a fairly good price for that option, but now I see that it is currently trading at 0.40-0.45, with the September 30 calls even fetching 0.15-0.20, so there is more to be had if you want to risk some money on the tail of the VIX distribution.
But what happens if the VIX spikes into the 20s like it did in the wake of February 27th or in June 2006? Not that much, if you think about options being tied to futures that are now two months out. Following February 27th, when the spot VIX made it briefly as high as 21.25 intra-day, the immediate jump in the May futures (two months out) was from 12.6 to 14.2, with these futures never rising above 15 during the life of the contract. Looking back at the June 2006 VIX spike to 23.81 one sees a similar story: the August futures (two months out) trended up from a May 10th low of 12.3 to a mid-June high of 18.7, but never even threatened to touch 20.
So these September 25s are not so much vulnerable to a VIX of 25 as they are to a VIX of 30 or so, at least until they get much closer to expiration. In the interim, mean reversion acts as a price cushion of sorts for VIX options and VIX futures. As expiration approaches, however, be wary of the price cushion turning into a pin cushion.
Wednesday, July 18, 2007
Individual Stock Volatility: InterOil Corp. (IOC)
In a nutshell, the InterOil story is of a massive natural gas find (perhaps 15 trillion cubic feet) with their Elk-1 well, which was announced about a year ago. Current drilling in Elk-2 is ongoing and speculation about the results of these efforts is what is responsible for the extreme volatility in this stock – enough to take the stock down 60% in three days.
I have appended a chart of the implied and historical volatilities below, as well as a current snapshot of the options. To put it mildly, these options offer some unusual and interesting possibilities, given that expiration is only two days away, volatility is sky high, and the likelihood of a significant news announcement during that period appears to be slim. To further sweeten the pot, IOC just happens to be trading at exactly the 22.50 strike as I type this, which makes short straddle, short strangle and butterfly possibilities particularly interesting.
Those thinking about selling volatility for the next two days, however, should give some serious consideration to hedging their exposure by considering an iron butterfly or an iron condor. This is a keg of dynamite, after all, but there is a good possibility it will not go off in the next two days.
Tuesday, July 17, 2007
Cdk5: the REAL Threat to the VIX
In brief, biochemists at the Picower Institute claimed to have isolated the molecular basis for fear and have successfully treated that fear in mice. In an article in Nature Neuroscience, Li-Huei Tsai, Picower Professor of Neuroscience in the Department of Brain and Cognitive Sciences, summarizes the research team's findings as follows:
"In our study, we employ mice to show that extinction of learned fear depends on counteracting components of a molecular pathway involving the protein kinase Cdk5. We found that Cdk5 activity prevents extinction, at least in part by negatively affecting the activity of another key kinase."If science can take the fear out of investing, whither the VIX?
Premature Demise?
The CXO Advisory Group has made a hobby of keeping track of how well gurus forecast the future of the markets and has concluded that as a group, the success of guru predictions averages a little worse than a coin flip.
For better or for worse, these statistics have not deterred Rob Schumacher of Van Kampen Investments from predicting that the VIX “may become as relevant as yesterday’s news.” Schumacher cites the elimination of the short selling “uptick rule” (Rule 10a-1 of the Securities and Exchange Act of 1934) as the culprit and argues that unencumbered short selling will lead to increased short sales and a corresponding decrease in demand for puts.
While no doubt some future put activity will manifest itself as short sales, the key question is one of scale, which quickly calls up issues of leverage, liquidity and transaction costs. My best guess is that the end of the uptick rule will have a negligible impact on put volume, as short sellers continue to favor the highly leveraged bets on baskets of large stocks that puts make possible. I also suspect that most market players ultimately believe blanket portfolio insurance is cheaper and more effective than point insurance – and the weaving together of a constantly moving thousand point quilt.
Finally, new legislation notwithstanding, it is always dangerous to bet against the popularity of any instrument that is setting new volume records, as VIX options did less than a week ago, just a couple of days after the uptick rule was eliminated.
If Schumacher is correct, then I can retire this blog and devote more time to becoming a better trader. If he’s wrong, I sure hope he has hedged his position with puts…
Monday, July 16, 2007
A Baker’s Dozen of Favorite Indicators
Investing, it turns out, is not much different. To the extent that you can keep things simple and have an uncluttered cockpit that still tells you everything you need to know to make it from point A to point B, you increase your chances of success.
Last week, a reader asked what my favorite market indicators are and it got me to thinking how I should be able to trade with only 12-15 indicators instead of the 25-30 that it seems I am always trying to pay attention to.
So…here is my attempt at spelling out a baker’s dozen of indicators that I would use if I were restricted to just this number:
General Market Overview:
- S&P 500 Index – with the standard 20/50/200 day SMAs
- NASDAQ Composite Index – with the standard 20/50/200 day SMAs
Market Breadth Indicators:
- McClellan Summation Index – my favorite of the advance-decline indicators
- New Highs Minus New Lows – I do a lot of work with individual stocks making new highs and like the way the 52 week high-low data complements the daily advance-decline data
Market Sentiment Indicators:
- ISEE – with a number of SMAs, including the 50 day SMA
- VIX – particularly the graph with the 10 day SMA combined with the 10% and 20% envelopes
- VWSI (VIX Weekly Sentiment Indicator) – while there is some overlap with the chart noted above, I include this because an increasing amount of my trading is driven by the VIX
Internal Market Trends / Speculative Behavior:
- Small Cap vs. Large Cap ratio – I tend to favor the RUT:OEX
- Emerging Markets vs. Developed Markets – while it hasn’t provided much in the way of exciting information as of late, I use the EEM:EFA
Three “Indicator Species” of Sorts:
- Oil – I prefer to watch the commodity, West Texas Intermediate Crude, but I also watch some of the ETFs closely
- Gold – again, I go with the commodity instead of various indices and ETFs
- The Long Bond – here I prefer TLT, the ETF for the 20 year Treasury, as I find it easiest to trade
And to Make it a Baker’s Dozen:
- Sector and Regional Strength Indicator – there are many ways to do this, but I like to sort ETFs by strength, as can be done on ETFScreen.com
Since I use Firefox, Flock and IE during the trading day, what I like to do is load all of the above indicators into tabs for my Opera start-up session, so that I can pop them open all at once just by starting Opera.
In the real world, I will likely find it difficult to wean myself away from all the other indicators that I use, but at a very minimum I urge all to prioritize their top dozen or so indicators and come up with some ideas about which ones to lean on most heavily when they are providing conflicting information and/or the markets are most volatile.
Sunday, July 15, 2007
Portfolio A1 Now 4.1% Ahead of SPX for Year
With four of the Portfolio A1’s five holdings – all except Odyssey Re Holdings (ORH) –
posting solid gains this week, the portfolio is now up 10.8% in the five months since the February 16 inception. This compares favorably with the 6.7% return by the benchmark S&P 500 index during the same period.
I do not have much else to say about the portfolio at this juncture, other than to note that when we pass the six month mark in another five weeks, I will start rolling out some statistics and analysis with respect to trading, risk, performance of holdings after they have been sold, etc.
There are no changes to the portfolio for the coming week.
A snapshot of the portfolio is as follows:
VWSI Lifts to +1
Closing at 15.15 for the week, up 0.43 or 2.9% from the previous week, the VIX does not feel particularly low to my untrained gut at current levels, but I must say that I was surprised to note that this is the second lowest close for the VIX over the course of the past 15 trading days.
This relatively low reading for the past 15 trading days is partly responsible for moving the VWSI off of zero to a +1 reading, meaning that while I am officially neutral on the direction of the VIX for the next week or two, there is a slight statistical bias in favor of a VIX rise.
Next week brings consumer prices, industrial production, capacity utilization, housing data, FOMC minutes, and even some Ben Bernanke testimony in to play. Of course, earnings season also kicks into high gear as well. What are the chances that these events will neatly offset each other and keep volatility in check? Even with the broad market indices making new highs, the VIX may not be as cheap as it looks.
(Note that in the above temperature gauge, the "bullish" and "bearish" labels apply to the VIX, not to the broader markets, which are usually negatively correlated with the VIX.)
Wine pairing: I am not sure how this happened, but I somehow neglected to mention my favorite of all the
In my previous roundup of California gewurztraminer, I suggested Navarro and Harvest Moon. For some of my top selections from Alsace, check out Trimbach; Hugel; and Domaine Weinbach. You can also check out the top-rated gewurztraminers in the 2007 San Francisco Chronicle Wine Competition.
Friday, July 13, 2007
The TradingMarkets 5% VIX Rule
TradingMarkets is one of many proponents of using the 10 day simple moving average of the VIX to help time one’s exposure to the broader markets. In their own words:
“The proper way to use the VIX is to look at where it is today relative to its 10 day simple moving average. The higher it is above the 10 day moving average, the greater the likelihood the market is oversold and a rally is near. On the opposite side, the lower it is below the 10 day moving average, the more the market is overbought and likely to move sideways-to-down in the near future.”
This wisdom is further distilled into what TradingMarkets calls The Trading Markets 5% Rule: “Do not buy stocks (or the market) anytime the VIX is 5% below its [10 day simple] moving average.”
Today the CXO Advisory Group is out with their analysis of the 5% rule. They conclude that “the TradingMarkets 5% VIX rule is of limited practical use and does not support a standalone trading strategy that keeps up with buy-and-hold.”
But before you click on to the next story, you should note that the CXO analysis actually goes far beyond an evaluation of the 5% rule and looks at returns for the S&P 500 index for all 1% increments from 0-10% above and below the 10 day SMA. CXO’s graph of the results, which I have included below, clearly shows that the 5 day SPX return is strongly correlated with increasingly higher readings in the VIX’s 10 day SMA. This should be of no surprise to regular readers, who by now are surely used to feeding at the trough of mean reversion.
The difficulty, according to CXO, lies in translating the VIX-related edge into a trading system that beats a buy and hold strategy, particularly when the 5% rule calls for being in the market only about 55% of the time.
My take is that the TradingMarkets 5% rule, just like the MarketSci.com approach I outlined last week, is a valid and tradeable way to use the VIX to time the markets. For better or for worse, for now I will leave it up to readers to see how well they can use this data to develop a robust trading system that can outperform a buy and hold approach.
As Emperor Joseph II was fond of saying in Amadeus, “Well, there it is.”
Thursday, July 12, 2007
New VIX Options Volume Record Yesterday
Yesterday marked another VIX options volume record, with the 322,484 contracts easily besting the previous record of 277,260 from back on May 16, 2007. I generally don't bother to mention this type of news, because I have yet to find a meaningful relationship between VIX futures volume or VIX options volume and subsequent market moves.
Given that it's a slow day from a VIX perspective, I thought I'd throw out the 'news' and see if any readers care to comment on VIX options volume and what it may tell us about the direction of the markets.
Wednesday, July 11, 2007
New Highs and New Lows for Market Timing
The McClellan Summation Index, the subject of yesterday’s market sentiment post, examines the difference between advancing and declining issues to help divine the future direction of the markets.
Today I am going to make the leap from daily advances and declines to daily new highs and lows covering a trailing 52 week period.
Before I dive in, I want to highlight the consistently excellent work of Headline Charts, a blog that regularly addresses issues such as advances and declines, new highs and new lows, as well as other market sentiment metrics. Today is no exception, as Headline Charts examines the ratio of new highs to new lows as well as the rarely seen inverse ratio, new lows to new highs.
I have also recently had the benefit of reading the encyclopedic and aptly titled market breadth tome, The Complete Guide to Market Breadth Indicators: How to Analyze and Evaluate Market Direction and Strength by Gregory L. Morris. This is obviously a labor of love and an indispensable resource for thinking not only about market breadth, but indicators of all types. Think of it more as a reference book than something to curl up with and you can get a better sense of its ideal application.
Spurred on by Morris’ research and analysis, I have been evaluating a number of market breadth indicators and am currently favoring a rather simple one for the intermediate term: new highs minus new lows, with a 4 day EMA smoother. One simple rule is to be long when the EMA is positive and short when it is negative. You can use a longer EMA or a SMA to smooth out the values a little more and cut down on whipsaws, but I like the 4 day EMA and will be adding this indicator to my short list of favorites.
You will note that the new high – new low indicator is currently recommending a long position in the markets, with a considerable cushion before it is likely to reverse.
Tuesday, July 10, 2007
Today's VIX Readings are Relatively Tame
It is going to take a VIX of at least 18.42 to move the VWSI to -6 and get me into the VIX options game today. At 16.77 we are currently still at a VWSI of 0.
The larger question, at least for me, is whether the recent pattern of higher lows in the VIX means we are ushering a new volatility trend. So far that is what it looks like, but I'd like to see at least one more month of data before I jump to any conclusions.
Good News from the McClellan Summation Index
The last time I talked about the McClellan Summation Index, I used a weekly chart to demonstrate how this indicator can provide some advance notice of market tops and bottoms.
Today my focus is more on the Williams %R momentum indicator that I have included with the daily chart of the McClellan Summation Index (which StockCharts.com codes as the $NYSI or NYSE Summation Index.) In this chart, which spans from 2003 to the present, I use 30 bars for the Williams %R indicator instead of the more common 14 bars in order to minimize some of the choppiness and provide more reliable signals.
In terms of a strong intermediate term bullish signals, what I look for in the chart below is for the Williams %R to cross the -50 center line, which is usually does shortly after moving above the -80 level. While I will generally wait for the official confirmation at the -50 level, you can usually anticipate that event when the %R rises above -80. With yesterday’s close of -77, I would expect that we would get another bullish signal from the McClellan Summation Index – Williams %R (30) very soon.
For those interested in checking the reliability of this indicator, you can eyeball the chart to determine that this center line crossover approach gave 9 highly profitable bullish readings, 1 neutral to unprofitable reading (May ’04), and 2 readings (February ’05 and February ’07) that were unprofitable – all of which one assumes a minimum holding period of 1-2 months.
Monday, July 9, 2007
Implied Volatility and Earnings Spikers
- Yahoo Finance, Google Finance, and other data providers sometimes list betas of 1.0 for issues they apparently have not calculated a beta for, particularly newer issues and foreign stocks
- highly volatile stocks that go in the opposite direction of the market for awhile can sometimes have low betas -- think small oil/gas exploration companies, gold miners, etc., but also consider that some tech stocks may countertrend for a long period and thus acquire a smaller beta than their volatility would suggest (historical volatility would be a better number to watch here, because it focuses entirely on the magnitude of the moves and does not care whether these moves are correlated to the broader markets)
- implied volatility is forward looking, so it automatically adjusts to account for scheduled earnings announcements, a pending FDA drug decision, a legal issue that is due to be resolved, buyout rumors, terrorism, violence in the Middle East, a hurricane that is bearing down on the US, etc.
Getting to the meat of the question, since I am looking forward in time to earnings, I pretty much ignore historical volatility and focus entirely on IV. I usually try to target the top 10% or so most volatile companies that are due to report in a 24 hour period, so that if it is mid-June and there are very few reports, I might look at IV as low as 35 (I generally consider 40 to be a minimum IV), but by the end of July to early August earnings peak, there will be so many small and extremely volatile companies reporting that it might be possible to screen out all companies with an IV below 50. Also, once you get over about 60 or so, I am not sure that a higher IV really translates to incremental future volatility in the short-term (unless we stray from earnings and talk about FDA decisions, etc.)
Regarding specific numbers, I use the current IV Index call number (the 44.20% from the SCHN iVolatility link), but the current IV Index put and current IV Index mean are usually so closely correlated that it doesn't matter which one you pick -- as long as it is a current number.
I also recommend that readers consider looking not just at the raw numbers but also at the 12 month volatility charts (such as this iVolatility chart for SCHN) where it is often much easier to visualize the size of the current pre-earnings volatility run-up – and also compare it to similar up-trending volatility patterns that preceded earnings in the past few quarters. In the case of SCHN, you can see a big jump in volatility during the past week and a sustained move since about mid-April. Implied volatility may not have been screaming “Buy!” in an unambiguous manner, but one can reasonably argue that at an 11 month high just prior to this morning’s earnings announcement, it was warning of the increased possibility of a big move in one direction or the other.
Finally, I would be would be remiss in not reiterating that directional earnings plays are highly speculative and usually carry a formidable risk/reward profile, so I recommend that anyone who plays the earnings lottery considers limiting their exposure with an options play or by making a bet on volatility instead of direction, as volatility typically – and much more predictably – decreases 15-20% the day after earnings are announced.
Sunday, July 8, 2007
Portfolio A1 Swaps Oils: PBR for TSO
For someone who is largely a discretionary trader, one of the more difficult aspects of a fully mechanical trading system is sitting on the sidelines trying to get up the enthusiasm to root for stock that you wouldn’t otherwise follow. Rarely do I watch Portfolio A1 dump one stock in favor of another, pump my fist in the air and yell at my monitor, “It’s about time, dammit!” Today is one of those days, however, as I can let my lukewarm feelings about the refiner Tesoro (TSO) depart along with the stock, while at the same time welcome into the Portfolio A1 fold Petroleo Brasileiro (PBR), the state-owned Brazilian whose stock has traced almost a straight line over the past five years in rising from 5 to 65, all while generally paying a 2% dividend in the process. PBR has been a favorite of my discretionary portfolios for several years and I can only hope that it hasn’t gotten ahead of itself at this stage.
Speaking of newcomers, last week’s strong portfolio performance was led by newcomer Mobile TeleSystems OJSC (MBT), whose 7.5% weekly gain helped to more than double the portfolio’s advantage over the benchmark S&P 500 from 1.5% to 3.3%. With Russia and now Brazil, 2/5 of the portfolio is invested in ADRs; and when you consider that portfolio stalwart Terex (TEX) has a strong China component, it is worth noting that Portfolio A1's stock ranking system is unwittingly endorsing the BRIC growth thesis, albeit with limited exposure to India.
Now that my discretionary portfolio overlaps this mechanical portfolio as far as
There are no other changes to the portfolio for the coming week.
A snapshot of the portfolio is as follows:
Saturday, July 7, 2007
Futures Now Available on VXN and RVX
More information is available from the CBOE for the VXN futures and RVX futures in the links to the left.
Among other things, this means I will now be paying much closer attention to the VXN and the RVX.
VWSI at Zero for Fourth Week in a Row
Volatility apparently used the 4th of July holiday as an excuse to take the whole week off, with the VIX falling 9.3% from 16.23 to 14.72.
It is unusual for the VWSI to register four consecutive weeks of a zero reading (it happens about once a year) and equally unusual to see a zero in eight out of eleven weeks. In the past, this type of flat line consolidation has not generally preceded a breakout in volatility, in contrast to some stocks that tend to trade in an increasingly narrow range before breaking out.
Keep in mind that Alcoa kicks off the earnings season on Monday, so things could change in a hurry.
(Note that in the above temperature gauge, the "bullish" and "bearish" labels apply to the VIX, not to the broader markets, which are usually negatively correlated with the VIX.)
Wine pairing: For an inexpensive Rhone blend, I continue to recommend: Oakley Five Reds; Robert Hall’s Rhone de Robles and Tablas Creek’s Cote de Tablas Blanc; Wrongo Dongo, the contrarian favorite from Spain; and The Stump Jump (I prefer the white over the red) from Australia. If you are looking for additional ideas, I encourage you check out the Rhone Rangers.
Friday, July 6, 2007
Dow 13,600 Links
I have fallen a little behind on posting some of my favorite recent links, so I’ve jettisoned many of the ones that are no longer timely, but have retained some from the past two weeks or so that I think may have a broader long-term application.
So without further ado, the next installment in what I have been reading and thinking about as of late…
- Paul Kedrosky at Infectious Greed reminds us that the volume of IPO registrations often help flag market tops
- Tim Knight of The Slope of Hope sums up the current market situation from his perspective (please note the top graphic…)
- Eddy Elfenbein of Crossing Wall Street calculates that the markets are up about 675,000% in the past 75 years
- Earnings season is just around the corner, and Bespoke Investment Group flags the high volatility plays
- …and has one of the better earnings calendars
- Forget T. Boone Pickens because Jim Kingsland of The Kingsland Report is calling for $85 Oil
- Chris Perruna looks for insights from a combined view of the NASDAQ and crude oil
- The CXO Advisory Group offers up the largest changes in P/E ratios
- Ticker Sense examines Fed Funds rates, pauses, and market performance
- Larry Nusbaum of Millionaire Now has a great graphic (and post) on US housing prices
- The CXO Advisory Group evaluates a strategy of selling index put options [For the record, while CXO and Bespoke may appear multiple times in these links, I have no affiliation with these parties, I just think they do excellent work]
- …and Roger Nusbaum offers some thoughts on the new Put Write Index
- …but Mebane Faber at World Beta has some cautionary notes and advice
- The CXO Advisory Group also says we shouldn’t bother with engulfing candlestick patterns
- Where do your new ideas come from? Pradeep Bonde at Stockbee shares some thoughts about his new ideas
- Zero Beta goes crazy (but has a lot of fun) playing with Google Trends
- Andy Swan thinks you can Prosper by lending money via the net
- The title says it all: from Barry Ritholtz at The Big Picture, “Your Choice in Media Determines How Uninformed You Are” (Pssst! It’s not too late to check out Bloglines and Google Reader)
- Another study concludes that organic food is better for you
- And finally, John Timmer at Ars Technica highlights a forthcoming paper which will attempt to establish that “the universe will destroy the evidence of its origin” (disclosure: I am long the universe at the time of this writing)
Thursday, July 5, 2007
Coming Soon…
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.
Tuesday, July 3, 2007
Using the VIX as a Timing Tool for the SPY
Since I am still playing a little bit of catch-up today, I am going to piggy-back on some third party content for today’s post. Specifically, I want to introduce some ideas from MarketSci.com on how to use the VIX to trade the SPY. In a three part series which I have linked below, MarketSci lays out three systems which use the VIX to time SPY trades. These include a long-term system using a 186 day VIX SMA which Barron’s cited in December 2006 as being developed by Credit-Suisse; an 11 day EMA-SMA VIX crossover system; and an 11 day EMA-SMA system which utilizes both the VIX and the SPY as triggers:
Part 1: Long-term Trading with the VIX – 20% deviations from the 186 day VIX SMA
Part 2: Short-term Trading with the VIX – an 11 day EMA-SMA VIX crossover system
Part 3: Our Spin on Trading with the VIX – a combined 11 day EMA-SMA VIX and SPY system
In many respects, these approaches are the SPY complement to the VIX mean reversion plays that I blog about on a regular basis in this space. Of course, unlike the VIX, trading the SPY has the benefit of being able to go long or short the ETF, use 2x leverage long with the SSO or short with the SDS, and use options on the underlying.
So far I have shied away from discussing the VIX as a market timing tool, but as I have increasingly become convinced of its applicability in this area, expect to hear more from me on this in the future.