VIX Drops Below 40

The last time the VIX was below 40.00 was on October 2, 2008

Watch the Baltic Dry Index in 2009

In 2009 investors will be scanning the globe for signs of economic recovery or deterioration. Among the many tools they should be watching in order to gauge the strength of global trade is the Baltic Dry Index (BDI.) The Baltic Dry Index measures shipping rates for dry bulk carriers that carry commodities such as coal, iron and other ores, cocoa, grains, phosphates, fertilizers, animal feeds, etc. In short, the BDI is an excellent proxy for global trade.

In the chart below, note how the BDI peaked after the S&P 500 index did in 2007 and bottomed after the SPX last month. The BDI may not be a leading indicator, but it is an important way to confirm whether moves in global equities are being reflected in an increase in global shipping. If the BDI fails to rally in 2009, be skeptical of any rally in stocks.

For those who are interested in following stocks of some of the leading dry bulk carriers, a good place to start is with Diana Shipping (DSX), DryShips (DRYS), and Excel Maritime Carriers (EXM).

[source: StockCharts]

VIX Close of 41.63 Is Lowest in Three Months

The last time the VIX closed below 42.00 was way back on October 1^st, when the VIX closed at 39.81.

Before anyone gets excited about the possibility of the VIX back in the 30s, I should note that the VIX futures continue to reflect expectations of a rising VIX over the course of at least the next 2-3 months. Today’s VIX January futures settled at 44.18 and the February futures settled at 45.08. Futures for August through October are now priced in the 37-38 range, however, suggesting that volatility expectations are being lowered for the second half of 2009.

Top Posts of 2008

Here are the top posts of 2008, based on the number of unique readers:

1. Ten Things Everyone Should Know About the VIX
2. Prediction: Direxion Triple ETFs Will Revolutionize Day Trading
3. What Is High Implied Volatility?
4. Volatility History Lesson: 1987
5. VIX November Futures
6. The VIX, VXV and Volatility Expectations
7. Strong Bear Signal from VIX:VXV Ratio
8. Arms Index Going Back to 1992
9. VXO Chart from 1987-1988 and Explanation of VIX vs. VXO
10. The VIX-SPX 30 Day Historical Volatility Spread and Performance
11. The Fallacy of the Bearish First Five Days
12. Fear and Flight to Safety
13. Overview of the U.S. Volatility Indices
14. Rare Batman Pattern Forming in the VIX
15. The Evolution of the Volatility Index Family Tree
16. Can Markets Bottom Without a VIX Spike?
17. VIX Numbers and Overbought Signals
18. The Significance of Double Tops in the VIX
19. VIX Spikes and the 2002 Market Bottom
20. Equities or Commodities?
21. SPY Put Volume Study
22. A Long-Term View of the Put to Call Ratio
23. The Rising Popularity of XLF Options
24. ISE Implied Volatility Charts
25. Is the Fear Bubble Bursting?

For those who may be interested, last year I compiled a similar Top 25 Most Read Posts of 2007.

ISEE Equity Call to Put Ratio and the End of the Year

Further to this morning's ISEE Put to Call Ratio at Highest Level in 16 Weeks, the ISEE equities only call to put ratio finishes at 198 -- the highest close since May 16, 2008.

The last time this index had back to back closes this high was 12/28 and 12/31/07.

It is worth noting that the only other year for which the ISEE equity only data is broken out is 2006; that year also had some higher than normal readings on the last four trading days of the year.

Given the brief holiday track record of the ISEE, my suggestion is not to dismiss the ISEE equity only data out of hand, but to take it with a grain of salt.

ISEE Equity Call to Put Ratio at Highest Level in 16 Weeks

The ISEE equity call to put ratio hit a 16 week high of 189 on Friday, as investors showed a strong preference for calls over puts. Today that ratio is even higher, at 215 as of 11:30 a.m. ET.

Trading is light so far and extreme values in the ISEE have a tendency to revert to the mean (146) as the day wears on, but coming on the heels of Friday’s high number, I believe the ISEE numbers should bear watching throughout the day.

For the record, the last time the ISEE equity call to put ratio was over 200 in a single session was back in the middle of May. At that time, the markets were just in the process of putting in a post-March top.

[source: International Securities Exchange]

End of Year Volatility Links

Now that the VIX is down more than 50% from its October peak, it seems as if everyone wants to talk about the VIX and volatility.

So…for the last time in 2008, here are some of the recent posts from around the blogosphere (with a heavy volatility flavor) that I have been chewing on for the past week or so:

• Credit Crisis – Signs of Progress (Prieur du Pressis, The Big Picture)
• Madoff’s Volatility (Felix Salmon)
• More Leverage (Adam Warner, Daily Options Report)
• Air Pocket Watch: November Hotel Occupancy (Paul Kedrosky, Infectious Greed)
• 2009: Already Looking Bleak (Mike Shedlock)
• Friday Market Sentiment (Headline Charts)
• Learning from Mistakes: The Short Sale Ban (Jeff Miller, A Dash of Insight)
• Spot the Difference in Volatility Levels (Peter Jacobson, Barron’s)
• The Relativity of Volatility & 100 Year Floods (Babak, Trader’s Narrative)
• The Volatility of the VIX: From Bear Panic to Barely Elevated (Brett Steenbarger, TraderFeed)
• Sentiment Surveys and the VIX (Peter Birchler, Stock Market Alchemy)
• Volatility, The VIX, S&P 500 and High Jump (Ian Woodward)
• Good Economic News for the Holidays: Volatility is Down (Ian Ayres, Freakonomics)
• Research Brief: Looking for Clues in Economic Volatility (James Picerno, The Capital Spectator)
• The Demand for Risk and a Macroeconomic Theory of Credit Default Swaps: Part I (Charles Davi, Derivative Dribble)
• Ideas for Volatile Times: Upside-Down Split-Strikes (Brian Overby, The Options Insider)
• Testing a Simple Index Covered Calls Strategy (CXO Advisory Group)
• International Long-Term Interest Rates (Bespoke Investment Group)
• ThinkorSwim ThinkAI (Emini Addict)

…a series of posts triggered by a Bloomberg article by Jeff Kearns and Michael Tsang’s VIX Fails to Forecast S&P 500 Drop, Loses Followers:

• Journalists Have a Responsibility Not to Get It Wrong (Mark Wolfinger, Options for Rookies)
• VIX Fails to Give You a Pony and Premature VIX Obituary Roundup (Condor Options)
• Bloomberg Says VIX Is Worthless (Don Fishback)
• VIX Searching for Its Mojo (Adam Warner, Daily Options Report)

…and VIX and More’s first mention in Barron’s:

• The Best Way to Use the VIX (Michael Kahn, Barron’s)

Chart of the Week: Gold

In a week in which most securities drifted lower on uninspired volume, gold was a notable exception, jumping 4.1% as tensions between India and Pakistan increasingly point toward the possibility of a military confrontation while violence in the Gaza Strip between Israel and Hamas is escalating.

Against the backdrop of potential conflict in either Gaza or the India-Pakistan region, gold surged above the critical 840 mark and ended the week at 871. As the uppermost of the two dashed black lines in the chart of the week shows, resistance from previous November-December 2007 highs was pierced this week. Gold also broke out of a down trending channel (solid black lines) this week and is now setting up for a possible large bullish move. If gold continues to rise, look for gold miners (GDX) to be even more volatile and likely outperform the commodity or the popular gold bullion ETF, GLD.

[source: StockCharts]

SPX Ten Day Historical Volatility at Lowest Level Since September 12

There are quite a few ways in which to measure historical volatility. Probably the most responsive of the time periods commonly measured is the 10 day historical volatility (HV) period, which covers the last 10 trading days. Variously referred to as statistical volatility, realized volatility, actual volatility, etc., the 10 day historical volatility measure for the SPX (dotted blue line in chart below) peaked on October 22^nd at just a fraction under the 100 level. On December 3^rd the 10 day HV was still holding strong at 89, but it has fallen precipitously over the course of the last three weeks and is down to just 35 as of Wednesday’s close and on target to dip as low as 33 or so today.

For comparison purposes, the 10 day HV in the SPX has not been below 35 since September 12^th, just prior to the Lehman bankruptcy.

The bottom line: while a VIX in the low 40s may look cheap at the moment, consider that the recent historical volatility in the SPX has been slightly more than three quarters of that represented by the VIX. Of course, the December holiday effect has artificially depressed volatility to some extent, but certainly cannot claim full responsibility for the drop in 10 day HV from 89 to 35.

[source: VIX and More]

The VIX Annual Cycle

Two years ago, when I was the only person reading this blog, I posted about VIX seasonal patterns in A Month By Month Look at the VIX. Since the original post I have received quite a few requests to update the chart with more recent data.

On the heels of yesterday’s VIX Holiday Crush, I am pleased to broaden the seasonal picture of the VIX with a current version of 19 years of VIX data as a composite annual cycle. The chart below has changed very little from the January 2007 version. In fact, 2008 followed the historical patterns established in previous years almost perfectly, with the VIX increasing in the January-March period, dropping through May and June, then spiking dramatically in September and October.

I have my doubts about whether this pattern will play out in future years, but the more times volatility wanders down this same seasonal path, the more time traders will be looking for a repeat in the following year.

[source: VIX and More]

VIX Holiday Crush

The VIX has been steadily declining during the month of December, from the high 60s on the first day of the month to the neighborhood of 42 as I write this.

Clearly the extraordinary measures taken by the government to pump liquidity into the system have been responsible for some of the shrinking volatility, but since I often talk about the holiday effect on volatility and frequently receive questions on the subject, I thought it would be a good day to share some of my research on the subject.

Since 1990, the month of December has averaged 21.05 trading days. The chart below captures each of those 21 trading days from 1990-2007 in composite form, with the mean for all December VIX values set at 100. In the chart, the pattern of decreasing volatility is most evident from the middle of the month to just before Christmas, during which period volatility drops from 2.4% above the December average (10^th trading day) to 4.8% below the December average (17^th trading day).

For the record, today is the 17^th trading day of December, which makes the the historical low point in volatility for December.

I will not go so far as to say the that calendar suggests today is likely to be the last time the VIX dips under 42 for awhile, but those with an interest in historical context may wish to prepare for an increase in volatility, as the holiday ‘calendar reversion’ effect wears off.

[source: VIX and More]

The VIX, Lehman Brothers, and Forecasting

Jeff Kearns and Michael Tsang of Bloomberg have an article out today (VIX Fails to Forecast S&P 500 Drop, Loses Followers) in which the authors contend that largely because the VIX failed to predict the October losses in the S&P 500 index (SPX), the VIX is no longer considered to be an accurate gauge of future market activity.

One of the central claims made by Kearns and Tsang regarding the lack of effectiveness of the VIX is stated as follows:

“On Sept. 11, less than a week before New York-based Lehman Brothers Holdings Inc. went bankrupt and four days after the government takeovers of Washington-based Fannie Mae and McLean, Virginia-based Freddie Mac, the VIX closed at 24.39. That meant traders bet the S&P 500 wouldn’t fluctuate more than 24.39 percent on an annualized basis, or about 7 percent in the next 30 days, and implied a range for the index of 1,161.11 to 1,336.99.

One month later, on Oct. 10, the S&P 500 closed at 899.22, or a record 23 percent lower than what the VIX predicted.”

As fellow blogger Don Fishback was quick to point out, the VIX calculation actually estimates one standard deviation of annualized 30 day volatility expectations in SPX options. That standard deviation, of course, is meant to capture 68.3% of the Gaussian or normal distribution of prices. In fact, the distribution of VIX prices does not follow a normal distribution, but even if it did, the movements from September 11^th to October 10^th would not be that statistically improbable.

Some quick comments on the math involved here. Using a VIX of 24.39, the conversion of an annualized volatility of 24.39% to 30 day volatility yields a 30 day volatility of 7.04%. Two standard deviations translate into a 30 day volatility of +/- 14.08% and should cover about 95.5% of the normal distribution (I am assuming a normal distribution for the sake of mathematical simplicity). Three standard deviations increase the range of expected volatility to +/- 21.12% and should capture about 99.7% of the normal distribution. In fact, the 99.9% boundary for the normal distribution is 3.29 standard deviations and translates into expectations of an SPX move of 23.16%, about on par with what transpired. So, given that an event which falls outside of 99.9% probability distribution happens once every 1000 instances. Rare indeed, but not unfathomable.

Of course there are many ways in which to utilize the VIX to aid in market timing. Consider that the nature of the VIX calculation is such that the VIX acts as an unbounded oscillator whose values are derived from prices paid for options on the SPX. Like most oscillators, traders tend to use extreme values as opportunities to bet on a reversion to the mean.

A good deal of the difficulty in understanding the movements of the VIX is that some of the dominant patterns are different over the course of different time horizons. For instance, in the short-term, the VIX commonly spikes and mean reverts. Looking at the intermediate term, the VIX frequently establishes strong trends; and in the long term, the VIX has a tendency to move in cycles of 2-4 years. For the month of September and most of the month of October, the VIX was in an uncharacteristically strong sustained uptrend.

Part of the reason for the sharp move in the VIX during September and October is that it is highly dependent upon macroeconomic and fundamental events that help to shape investor perceptions of uncertainty, risk and fear. In the week leading up to the Lehman Brothers bankruptcy, for instance, very few investors believed that the government was prepared to let Lehman fail. Additionally, in retrospect is seems as if those who did believe failure was an option did not comprehend the nature of the systemic reverberations that a Lehman bankruptcy would trigger.

The bottom line is that during the second week in September, the VIX was pricing in a very low probability of a Lehman Brothers bankruptcy. Perhaps more important, investors were also assigning a significantly lower systemic threat potential as a result of the dominoes associated with a Lehman bankruptcy.

Ultimately, it took a full six weeks of a steadily trending VIX for the market to fully price in the global systemic risks associated with the sequence of events that began with the Lehman Brothers bankruptcy.

Consider that the prices and implied volatilities of SPX options have to account not just for the probabilities associated with various future scenarios, but also the magnitude of the impact of those scenarios on the stock market. For this reason, even while some of the probabilities may not have varied significantly from day to day during September and October, as the magnitude of the financial crisis was slowly revealed, the VIX continued to ratchet higher – and investors reacted to a rising VIX with increasing alarm.

Getting back to the question posed by Kearns and Tsang, yes the VIX underestimated future volatility back on September 11^th. At that time, the prediction of a four year flood was consistent with mainstream thinking. Very few observers anticipated the SPX falling below 800 by Thanksgiving.

As the year winds down, I will have more about what we learned about volatility in 2008 and what some of the implications are for 2009 and beyond.

Recognition for VIX and More

It is always nice to be acknowledged for the contributions you make, but it is particularly heartening when that recognition comes from a respected peer in the field. For that reason, I was pleased to see that Condor Options has included VIX and More in its list of the Top Finance Blogs of 2008.

The recognition is even more meaningful when I see the esteemed company this blog has on the list:

• Ultimi Barbarorum
• Quantifiable Edges
• MarketSci
• Daily Options Report

While these should all be familiar names to VIX and More readers, I do not believe I have yet featured the work of Ultimi Barbarorum on the blog. If so this omission is accidental, as Ultimi Barbarorum is a true thinking man’s blog in which the reader is treated to one side of the author’s ongoing dialogue with Baruch Spinoza. What could be a better way to pay tribute to the closet philosopher in all of us?

Chart of the Week: Fed Funds Rate Drops to 0.11%

Thanks to the Federal Reserve’s decision to drop their target Fed Funds rate to an all-time record of 0.00% to 0.25%, the subject of this week’s chart of the week is a no brainer.

The Fed has 55 years of Fed Funds rate data and I have chosen to highlight not the target rate announced by the FOMC, but the daily effective federal funds rate, which is a volume-weighted average of rates on trades arranged by major brokers.

Not surprisingly, Friday’s effective Fed Funds rate of 0.11% is a record low, but that record was actually established on December 10^th and tied again on Friday.

For history buffs, the record high of 22.36% dates back to July 22, 1981. The average Fed Funds rate since 1954 is 5.62%.

[source: Federal Reserve Bank, VIX and More]

VIX Drops Below 42; VIX Calls in Play

The range-bound action in equities over the last few weeks has brought us something we have not seen since October 3^rd: a VIX below 42.

With the VIX futures for January and February still trading in the 47-48 range, the consensus opinion is that a 42 is not sustainable. In fact, supporting that opinion is the flurry of activity in the January 70 and 75 calls in the past few minutes, as speculators (and perhaps hedgers) jump at the pre-Christmas sale prices on VIX options.

The graphic below summarizes the action in the VIX January options, with almost all of the action in the January 75 calls coming as I type this.

[source: optionsXpress]

First Sell Signal from VIX:VXV Ratio Since August

The VIX:VXV ratio has just triggered its first sell signal (for the SPX/SPY) since late August as a result of the VIX falling to the current level of 44.60.

Note that even though the holiday season typically has lower than normal volatility, I do not recalibrate the ratio or the signals to account for seasonal tendencies.

Performance Implications of VIX and SPX Divergences

I have frequently posted about the issue of SPX and VIX correlations, but some of the comments following yesterday’s SPX Straddle Case Study Update indicate that it is time to dust off some statistics and address some of the issues that have been raised.

Reader Nirvanic lays out his thinking on the subject as follows:

“What I call a VIX/SPX non-confirmation, meaning that both the SPX and VIX were red. One of my main rules is that the VIX and the SPX cannot be the same color. When this happens there is something wrong. If the VIX and the SPX are green, then usually the SPX will go red and the same in reverse.

I have only seen a few days lately where there was a VIX/SPX non-confirmation. They are rare and so I don't have a lot of data on these. In the occurrences I have seen, the VIX has been the 'tell.' If this holds true, then tomorrow should be a green day because the VIX was right, not the SPX.”

Let me start out by saying that one of the my most read posts of 2007 was titled High Positive Correlation Between VIX and SPX Often Signals Market Weakness. The post is probably worth checking out just because it has one of my favorite photos on the blog, but of greater interest is likely one of my conclusions that “in looking at past periods of high positive correlations between the SPX and the VIX, it is notable that the SPX generally performs well below its historical mean for up to three months following the high positive correlation period.”

Nirvanic’s contention is more specific. His “non-confirmation” days are probably a lot more common that he realizes. Going back to 1990, when the VIX ends the day in the red, the SPX also closes down about 21% of the time. When the VIX is green, non-confirmation is even higher, at about 25%.

In terms of performance, it is easy to think of the possibilities as a 2x2 matrix, with the VIX either up or down on a daily basis and the SPX negatively correlated or positively correlated with the VIX.

Let me summarize the considerable research I have done on the subject by saying that if there is one pattern among the four that is most predictive of above average future returns, it is the one in which the SPX finishes the day in the red while the VIX finishes in the green. Conversely, as Nirvanic suggests, the pattern associated with below average future returns is the one in which the SPX is up and the VIX is up.

Each of the two remaining patterns demonstrates very little variation from typical market performance; in fact the SPX down, VIX down pattern slightly outperforms the SPX up, VIX down pattern.

Note that all data cited above reflect single day changes in the SPX and VIX. At some point in the future I will share some of my research into longer-term changes in the SPX and VIX patterns, as well as their trading implications.

SPX Straddle Case Study Update

I mention very few possible trades on the blog and when I do so it is always for illustrative purposes only. As a consequence, I rarely feel an obligation to follow up on a previous post that identified a possible trade.

Today, however, seems like an opportunity that is too good to overlook because the timing and the math just happened to work out so nicely.

Exactly one week ago, in Is the SPX Going to Stick Close to 900?, I outlined my opinion that I thought there was a strong chance the SPX “would settle in a trading range of 820-980.” I also mentioned the “possibility that the SPX might start to feel some gravitational pull around the 900 mark and start trading in an even narrower range, with the 900 area becoming a No Man’s Land of sorts.”

For those who might have similar thoughts about the market and were looking to harvest some volatility as income, I suggested a menu of strategies that included straddles, strangles, condors, and butterflies.

I chose to illustrate one possible range bound trade with a short straddle using the S&P 500 index (SPX) as the underlying. With the SPX trading at just a shade over 900 at the time, the puts and calls could each be sold for 30.00 per contract. Fast forward one week and the SPX is still hovering around 900. After one week of time decay and a VIX that has fallen approximately 10% during that period, both the puts and calls have had their prices cut in half, from 30.00 to 15.00.


As expiration approaches, options trades move from the realm of investment to crap shot, but it is interesting to see a real life case study in time decay in which all the numbers behave as they normally do only in a textbook.

[source: optionsXpress]

VIX Trends Around FOMC Announcement Days

I have recently received several requests to update research I posted in the first month of the blog (January 2007) under the title of VIX Price Movement Around FOMC Meetings.

The general pattern identified almost two years ago is still intact. In the chart below, I have aggregated the data for 19 years of VIX history covering a period spanning ten days before to ten days after some 150+ FOMC meetings. With the closing VIX price on the Fed days indicated by a black dot, it is easy to identify a pattern of volatility increasing in the week prior to the announcement, then dropping dramatically for three days following the announcement, and slowly building back to pre announcement levels thereafter.

Not surprisingly, one of the most predictable aspects of the VIX is that it has a tendency to increase dramatically on the day before the announcement as anxiety builds about possible changes in Fed policy, then drop by about 2.3% on the day of the announcement as the markets discover that the worst fears were not realized and/or the Fed’s actions and statements had been largely discounted in advance.

For a more detailed interpretation, check out my commentary in the January 2007 post.

[source: VIX and More]

VIX Term Structure Changes Since November 20th

The VIX term structure is a series of calculations of implied volatility on SPX options stretching out months and years into the future. The terms structure highlights how future expectations of volatility in the SPX as derived from IV data reflect changing expectations about how volatility will evolve over time.

The concept is best illustrated with an example.

In the chart below, I have plotted the VIX term structure from November 20, 2008 and again at the close on last Friday, December 12. November 20^th marks the high water mark for the term structure, when implied volatility for the SPX options closed at their highest levels of the year. The current data shows how implied volatility has fallen dramatically in the front months and incrementally in the second half of 2009 and beyond.

At this stage, market participants are anticipating market volatility will peak in February at about 57, then gradually decline to a level in the 43-44 range by the end of 2010. In contrast, back in November, traders were of the opinion that SPX implied volatility (the VIX) was extremely extended and would mean-revert rapidly, as has been the case.

One way to think about the difference between the November 20^th term structure and the December 12^th term structure is that the change represents the amount of volatility, risk or uncertainty that has been removed from the S&P 500 index during the course of a little over three weeks.

[source: CBOE]

Chart of the Week: U.S. Dollar Reverses Down

There were many strong candidates for the chart of the week, but this week’s honor goes to the U.S. Dollar, which saw its largest one week drop in percentage terms in at least 25 years.

As the chart below shows, the dollar has been negatively correlated to stocks for the past five months or so. Historically, a falling dollar has generally not been positive for stocks. It will, however, provide some support for exporters and enhance demand for commodities that are quoted in dollars across the globe.

For the most part, the strength of the dollar usually reflects traders’ opinions about the strength of the U.S. economy relative to economies associated with the other major currencies. When the dollar was rising, therefore, it was not necessarily a vote of confidence in the U.S. economy as much as it reflected a concern that other nations may be in an even more difficult situation. Now with the mushrooming U.S. debt on top of an already severe economic crisis, the prospects for the U.S. economy relative to that of some of other global economies is being reevaluated from one of the strongest to perhaps only slightly better than average.

The dollar appreciated approximately 23% from July to November. This week the dollar moved below its 50 day moving average for the first time since the July bullish move again. Trend indicators such as the Aroon are starting to reflect a reversal in trend; expect trend-following systems to be short the dollar as the new trend becomes more pronounced.

Do not be surprised to see half of the 23% gain disappear in the next few months.

[source: StockCharts, VIX and More]

Are FAS Options Cheap with an Implied Volatility of 232?

Generally the thought of buying some options on the cheap is not consistent with an implied volatility (IV) of 232.

Today, I have a counterexample to consider.

Take the case of FAS, one of the new Direxion triple leverage ETFs. FAS is intended to track 300% of the price performance of the Russell 1000 Financial Services Index. In the recent market environment this has proven to be a daunting task, resulting in FAS racking up a 30 day historical volatility number of 332 – a full 100 points higher than the current implied volatility.

In practical terms, an IV of 232 translates into an anticipated average change of 14.6% per day. For comparison purposes, an IV of 332 translates into an average daily move of 21%. So far the mean one day change in closing prices for FAS has been 17.4%. Looking at recent history, an implied volatility of 232 may turn out to be a bargain and options in FAS may not be as expensive as they look…

[source: International Securities Exchange]

Not a Whiff of Panic

For all the talk about the auto bailout fiasco, a little more than two hours into the final trading session of the week finds the markets relatively unchanged since last Friday. As I type this the SPX is hovering around the 862 mark, down about 1.5% for the week.

Interestingly enough, the VIX has also fallen this week and is currently down about 4.4% from last week’s close. In fact, the VIX is setting up for the sixth close in a row of under 60 – the first time this has happened in over two months.

Shorts had an hour or two of fun yesterday, but the buy on the dip crowd appears to be back out in full force today, with technology, small caps, real estate and homebuilders catching a bid.

As long as the VIX keeps dropping, it is reasonable to assume that buyers will continue to step in aggressively to support the market when it pulls back.

At the very least, expect bears to start to lose their nerve if the current pattern continues.

Where Is the Leadership in this Rally?

For the last three weeks, I have been impressed by the confidence and resolve shown by the bulls as they have consistently used pullbacks to flood the market with new long positions. Perhaps algorithms have no fear…

More recently, however, as the bull leg has stalled around the SPX 900 mark, I have found myself thinking about the lack of ‘proper’ leadership. Yesterday and today, the rallies have been led by commodities, with gold and energy equities the top performers.

At the same time, the three sectors I think are most critical to the recovery, my so-called ‘indicator species’ sectors (financials, homebuilders and consumer discretionary stocks), have been unable to get out of the red today.

I am not sure where the leadership will come from that will eventually push the SPX back over 1000. Today large cap technology names First Solar (FSLR), Apple (AAPL), Dell (DELL), Research in Motion (RIMM), eBay (EBAY) and Intel (INTC) are all strong performers. Frankly, I would expect technology to play a strong role in the next big leg up, but leadership may come from a number of other sectors.

There are few guarantees in the stock market, but I can guarantee that gold and energy are not going to pull the SPX up over the 1000 mark and leave financials (XLF), homebuilders (XHB), and consumer discretionary stocks (XLY) behind.

[source: StockCharts]

VIX Closes Under 60 For Fourth Consecutive Day

Today's close was 55.73

The last time the VIX closed under 60 five days in a row was on October 8th. Just to set some historical context, the VIX was trading in the 30s at the beginning of that five day stretch.

Strange Rally, With Gold and Energy Up, Financials Down

For what it's worth, I'm short right now, as among other factors I am suspicious of a DJIA that is up 187 points largely behind strength in gold and the energy sectors.

Meanwhile, financials are in the red.

Will financials pull the broader market back down? Will commodities lift the market higher?

The more I think about it, the more I think we are moving closer to a deadlock and the more I like that SPX straddle trade...

Is the SPX Going to Stick Close to 900?

It is generally my intent at VIX and More not to recommend specific trades, but to highlight different ways to think about volatility. With that in mind, consider that during the past three days, the S&P 500 index (SPX) has straddled the 900 level in the closest thing to a sideways trading range since August.

Since the November 21^st low, I have been anticipating that the SPX would settle in a trading range of 820-980. So far the SPX has not traded north of 920, but I would not be surprised to see this happen.

What is even more interesting is the possibility that the SPX might start to feel some gravitational pull around the 900 mark and start trading in an even narrower range, with the 900 area becoming a No Man’s Land of sorts.

If the No Man’s Land scenario plays out even for just the next seven days, it is possible to lock in some nice gains with a straddle (or strangle, condor, butterfly, etc.) on the SPX, the SPY, or one of the leveraged variants.

As the graphic below from optionsXpress shows, the bet is essentially that the SPX will remain in a range of 60 points in either direction (a little less than 7%) in a little less than 7 trading days. The bottom line: seven percent in seven days. Volatility tends to decrease during the holidays, which would be a positive factor for those who choose to sell volatility.

If you are thinking about how one of the new 3x ETFs might play out in a similar trade, BGU is currently trading near 36 as I type this and a short straddle would be profitable in a range of about 28 to 42 – essentially a range of 20% in either direction.

[source: optionsXpress]

BRIC Update: China a Leader or Outlier?

I have commented on resurgent Chinese stocks several times in the past few weeks, most recently in China About to Break Out? Now that Chinese stocks (FXI, black line) appear to be on the rebound, an important question is whether this is an isolated phenomenon or one that will also affect other emerging markets economies.

As the chart below shows, the rally in Chinese stocks has significantly outdistanced the recent bounce in emerging market stocks (EEM, orange line). It is the other three members of the BRIC group, however, that are lagging China and the broad emerging markets group the most. Not surprisingly, commodity-rich Russia (RSX, blue line) is the biggest laggard among the BRIC countries, while India (EPI) and Brazil (EWZ) are trailing the broader emerging markets index, but performing better than Russia.

The question of whether growing domestic demand and a massive government stimulus package will result in a China-specific rebound or help pull other global economies along for the ride is not likely to be answered soon. In the meantime, China looks strong on a relative basis and other emerging economies should be watched closely for clues about the geographical breadth of the rally.

[source: BigCharts]

The Direxion Triple ETF Revolution Has Arrived!

Three weeks ago last Friday I thought I may be sticking my head out a little too far in Prediction: Direxion Triple ETFs Will Revolutionize Day Trading. Well, here we are barely three weeks later and these triple ETFs are racking up more volume in the first half hour of today’s session than they did in an entire trading day when I made my original prediction. (see graphic below)

In short, the revolution has already arrived.

Sure, there have been some issues with tracking error as Adam at Daily Options pointed out in Triple the Fun. On an intra-day basis, however, these ETFs seem to track and trend relatively accurately. And if you get the direction right, are you really going to be upset that you were right a factor of say only 2.7 times the underlying instead of an advertised multiplier of 3.0? Either way, it was still probably a wise allocation of capital.

The next frontier may turn out to be options strategies associated with these 3x and -3x ETFs. All eight of these ETFs are optionable and options activity seems to be picking up rapidly, particularly in BGU, the large cap 3x bull ETF, which currently sports an implied volatility of about 150 and a historical volatility in excess of 200.

[source: Yahoo]

The Significance of Double Tops in the VIX

The following is adapted from a subscriber newsletter segment that appeared in the November 26^th newsletter.

I have never seen any research on the subject of VIX double tops, but given the recent double top formation in the VIX, I thought this might be a good time to share some of my thinking on the subject. First, the chart at the right shows the recent VIX levels from mid-August to the present. The first spike in the double top comes on October 24th and the most recent spike comes on November 19th.

Double tops are fairly common in the 19 year history of VIX data and frequently coincide with extreme readings in the VIX. By contrast, VIX triple tops are relatively rare; and while single VIX spikes are common in more mundane market conditions, they are less likely to be found at VIX extremes than double tops.

In fact, prior to this year, the three crises with the most extreme VIX readings were the 1997 Asian Financial Crisis, the 1998 Long-Term Capital Management Crisis, and the 2002 bottom of the technology bust that accompanied the WorldCom bankruptcy filing. In the graphs below, I have recorded the history of these VIX spikes. You can clearly see a double top pattern in the VIX in all three instances. Interestingly in each instance, the spikes were separated by approximately 2-3 weeks and signaled major turning points in the markets.

Recent events have shown that extrapolating from past chart patterns to the current market is fraught with danger, but I would argue that the presence of a VIX double top reinforces the case that the recent stock market bottom will prove to be an important market inflection point.

[source: Yahoo, VIX and More]

Chart of the Week: Economists Try to Predict Payroll Losses

The word of the year may be bailout, but when it comes to the stock market, the operative word for this week is resiliency.

On Tuesday, Wednesday and again on Friday, stocks shrugged off bad news and sharp declines to post solid gains. Yesterday’s feat was perhaps the most impressive of all, after November nonfarm payrolls shocked even the most pessimistic estimates by falling 533,000. Following the release of the employment data, the Dow Jones Industrial Average was down 292 points (3.5%), before putting on a furious 638 point (7.9%) rally and eventually ending the day with a 259 point gain, up 3.1% from Thursday’s close.

This week's chart of the week captures the payroll predictions of the 73 economists surveyed by Bloomberg prior to the release of the employment report. The actual nonfarm payroll number of -533,000 is more than four standard deviations away from the mean prediction and is indicated by the dotted black line to the right. Given that this result triggered a 3.1% rally, one wonders what might have happened to stocks if the employment data had been near the median prediction of a 333,000 loss or perhaps even the more optimistic projections of a loss in the vicinity of 220,000.

Going forward, economic data releases are on the light side until the end of next week, but watching how stocks react to the news flow next week may go a long way toward determining the character of the recent buying activity.

[source: Bloomberg, VIX and More]

Breaking Down the Financial Sector Post-Lehman

For most of 2008, the three sectors I have been watching most closely to gauge the health of the economy are financials (XLF), homebuilders (XHB), and consumer discretionary stocks (XLY). I have even referred to these sectors as my ‘indicator species’ sectors, as I am of the opinion that unless all three of these sectors are healthy, the health of the broader economy cannot be assured.

In the past two weeks, relative strength all three of the above sectors has helped the broader market indices put in what is no less than a provisional bottom. Financials have been the most consistently strong sector, with the XLF financial ETF now 35% above its November 21^st low.

In the chart below, I have attempted to break out the relative performance of various financial sectors over the past three months, using four ETF from the financial sector specialist Keefe, Bruyette & Woods (KBW). The chart dates back to September 5^th, ten days before the Lehman Brothers bankruptcy. The baseline ETF (black line) is KBE, which tracks the KBW bank index. The top performer among the other three ETFs is KRE, the KBW regional banking index. The two laggards are KIE (KBW insurance index) and bottom-dweller KCE (KBW capital markets index.)

In relative terms, insurance and capital markets seem to have enjoyed the more impressive bounce off of the November low. Regional banks, which actually showed small gains in September, have been acting more sluggish as of late. More dominoes are certain to topple as the ripple of the financial crisis continues to broaden its reach, but the recent relative strength in insurers and investment banks bodes well for the financial sector, which just might provide leadership when the next bull leg commences.

[source: BigCharts]

China About to Break Out?

It was only ten days ago that I thought I would be provocative with an early call on China in Time to Be Long China? Since that time, what looked like a possible cessation in downside momentum has turned decidedly more bullish, with the FXI rising an additional 10%.

The chart below shows FXI, the iShares FTSE/Xinhua China 25 Index ETF, closing above its 50 day simple moving average (SMA) for the first time in 4 ½ months yesterday. It has been 27 trading days since the FXI put in a bottom. Since that time, the Chinese ETF has rallied more than 40% off of that bottom.

If FXI can close above its 50 day moving average again today, it will mark the first time in over six months that FXI has closed above that important technical level on consecutive days. Ten minutes into today’s session, FXI is trading at 26.70, down 0.55. With the 50 day SMA at 26.94, any close at 27.00 or above should leave a fairly bullish signal on the chart and support the case for increasing upside momentum.

[source: StockCharts]

Arms Index Going Back to 1992

I’m glad to see that yesterday’s Arms Index Extremely Extended post received so much attention.

One of the concerns raised by a reader was that my chart of the Arms Index (TRIN) only looked back to four years of history, so that the historical context prior to the current bear market consists entirely of bull market readings. For this reason, today’s chart goes all the way back to the beginning of TRIN data available at StockCharts.com.

In the chart below, the 17 years of TRIN data results in such compressed and difficult to read 10 day EMA cycles that I have lengthened the exponential moving average period from yesterday’s 10 days to a 30 day EMA. Fortunately, because it is an EMA instead of an SMA, the peaks in the TRIN cycles are almost identical whether the EMA period is 10, 30 or 50 days.

I have also removed the red and green horizontal lines from this long-term chart to reflect the fact that the TRIN had a lower mean prior to 2000, trended higher during the bear market from 2000-2003, and seems to have found a new mean value from 2004 through 2008. For this reason, considered over the course of multi-year time frames, the TRIN is best thought of in relative terms rather than absolute terms.

As I noted with yesterday’s chart, spikes in the TRIN have “historically provided excellent buying opportunities.” Low TRIN readings may also have some value from a market timing perspective, but these signals are generally not as robust as high TRIN readings. Finally, the TRIN is far from perfect in predicting market inflection points, but it does have a track record that is accurate enough to bear watching. As I noted yesterday, the TRIN is best suited for short to intermediate-term setups.

[source: StockCharts]

Arms Index Extremely Extended

The Arms Index or TRIN is an indicator that I watch closely for short to intermediate-term setups. The indicator which combines ratios of advancing issues to declining issues and advancing volume to declining volume is a reasonably reliable contrary signal.

Since mid-October the Arms Index has been generating a number of historically high signals. In the chart below, I used a 10 day exponential moving average as a smoothing factor. Note that the TRIN’s 10 day EMA appears to have climaxed yesterday in the manner that has historically provided excellent buying opportunities. To my ears, yesterday’s climax in the TRIN is suggesting that the November 21^st bottom is likely to hold. Shorts beware…

[source: StockCharts]

A Graphical History of the ISM and the S&P 500 Index

I am sure many out there are wondering just how bad an Institute for Supply Management (ISM) index of 36.2 is in the historical context and just what it may mean for the stock market.

Rather than a bunch of statistics, I thought the chart below might help. It identifies the six previous instances since 1950 in which the ISM index dipped as low as the current level.

Not surprisingly, historical precedent recalls a number of difficult economic periods. What I find particularly interesting is that, consistent with the belief that stocks are a leading indicator, when the ISM bottomed, this was often after stocks had made a substantial move off of their eventual bottom.

[source: Institute for Supply Management, VIX and More]

VIX Drops 30% in Five Days for Eighth Time in 19 Years

A reader asked about the historical significance of the VIX dropping 30.9% in the last five trading sessions. This has only happened six times since the beginning of the VIX data history in 1990. If we lower the bar to a 30% drop in five days, we pick up a total 8 instances; and if we move the threshold down to a 25% drop in five days, the number increases to 32 occasions, including quite a few data points that fall on consecutive days.

If you do this type of analysis often enough, you begin to be able to pick the years that will be most prominent on the screen: 1991, 1994, 1997, 1998, 2002, and 2007. Now 2008 is starting to make its impression in the historical database as well.

The question most people are interest in, however, is not so much the year of the previous instances as the subsequent performance of the stock market in the days and weeks following these 30% drops. The data show almost identical performance patterns for 25% and 30% five day drops in the VIX. Essentially, there is a very strong probability that during the next five days the SPX will be down at least 1% or more. Following the classic mean reversion tendency, in looking out 10 trading days or more, the underperformance gap begins to diminish significantly, so any shorts opened today should have an anticipated lifespan of 10 days or less.