Thursday, April 30, 2009

Selling VIX Puts with the Help of a Put Matrix

The VIX was at 51.65 when the SPX formed its “devil’s bottom” at 666.79 almost two months ago. Since then, the SPX has gone up almost exactly one third and the VIX has dropped almost exactly one third. As the SPX continues to rise – recently breaking through an important resistance level at 875 – the VIX seems somewhat reluctant to continue lower. This is consistent with my statement of two weeks ago that “my personal forecast is for the recent decline in volatility to drop to no lower than the 30-32 level before flattening out.”

A floor in volatility does not necessarily mean that the VIX is destined to spike back up toward 50. It does, however, mean that some interesting VIX options trade may present themselves. For instance, if you believe that the VIX is not likely to stay below 35, you can sell a VIX put and capture a fair amount of premium with little downside risk. While ‘little’ is a subjective term, VIX puts are less risky than other naked puts because while volatility has a tendency to spike up, the path down (except from upward spikes) is almost always a gradual one.

With this in mind, I want to highlight an options matrix feature that optionsXpress has on their site. Customers can create either a call or put matrix for any optionable security and view the bid and ask prices over the next six months in a matrix format. The graphic below shows VIX puts from May to October at all strikes from 10 to 100.

If you study the chart, you can see a great deal of interesting information. Regarding the possibility of a VIX put floor, you can see it priced in. VIX May 35 puts can be sold for 1.90 at the moment, while the June 35s fetch 2.75. Going out further in time, however, yields very little in the way of incremental premium. The July 35s are bid at 3.10, the August 35s at 3.30, the September 35s at 3.40, etc.

For some additional fun, check out the bids for the 60 puts. They are almost identical for each month from May through October. Why? Part of the answer is that mean reversion is built into the options prices.

VIX options have some interesting quirks that take awhile for most investors to internalize. By looking at a put matrix or call matrix, however, it is much easier to get a sense of what types of future VIX moves are built into VIX options prices.

[source: optionsXpress]

Disclosure: Long VIX at time of writing.

Commercial Real Estate Blogs

Since I have been beating the commercial real estate drum for the past week or so and plan to move on to other topics, I think it is only appropriate to pay homage to some of the blogs that tackle CRE on a full-time basis.

Frankly, the pickings are slimmer when it comes to commercial real estate blogs than residential real estate blogs, but there are still quite a few excellent sources of information. Three of my favorites are Deal Junkie, Llenrock and Real Property Alpha.

A broader list of some commercial real estate blogs worth checking out includes the following:

Wednesday, April 29, 2009

Three Commercial Real Estate Sub-Sector ETFs to Watch

I plead guilty to treating commercial real estate as a single homogeneous entity in my two previous commercial real estate posts, Commercial Real Estate Problems Piling Up and Moodys/REAL Commercial Property Price Index.

The truth is that while there are a wide variety of REITs out there that span the full range of commercial real estate activity, my focus is mainly on ETFs and when it comes to ETFs, most of the popular real estate ETFs are of the large catchall variety, such as IYR, ICF, VNQ and RWR.

While I am not aware of any ETFs that are pure plays on shopping center REITs, office REITs or apartment REITs, there are three commercial real estate sub-sector REIT ETFs that can help sort through various sectoral trends within the REIT universe. The three sub-sector ETFs, with their allocations as of April 28th are as follows:

FTSE NAREIT Retail Capped Index Fund (RTL)

  • 52.28% Equity Shopping Centers
  • 35.85% Equity Regional Malls
  • 11.47% Equity Free Standing
  • 0.20% Short-Term Securities

FTSE NAREIT Industrial/Office Capped Index Fund (FIO)

  • 54.87% Equity Office
  • 26.92% Equity Industrial
  • 17.93% Equity Mixed

FTSE NAREIT Residential Plus Capped Index Fund (REZ)

  • 41.98% Equity Apartments
  • 39.02% Equity Health Care
  • 15.35% Equity Self Storage
  • 3.37% Equity Manufactured Homes
  • 0.07% Short-Term Securities

For the record, the limited liquidity for RTL and FIO makes them better indicators than trading vehicles, but REZ is actively traded.

As the chart below shows, the retail and industrial/office REIT ETFs have moved almost in lockstep in the post-Lehman world, while the residential ETF fared better in the downturn, but has been a little more sluggish during the bounce off of the March bottom.


Moodys/REAL Commercial Property Price Index

Last week, in Commercial Real Estate Problems Piling Up, I opined that commercial real estate is a likely candidate to usher in the next leg of the financial crisis. Since the S&P/Case-Shiller Home Price Index gets so much publicity, I thought this would be a good opportunity to mention a commercial real estate index that deserves more attention: the Moodys/REAL Commercial Property Price Index.

This index was last updated April 24th and shows that prices have dropped slightly more than 20% since the October 2007 peak.

While residential prices are important to watch, most of the residential story has already been told. The rest of the real estate story – good or bad – likely lies on the commercial side.

[source: MIT Center for Real Estate, Real Capital Analytics]

Tuesday, April 28, 2009

HOGS Gets Slaughtered

I am far from being an expert on swine flu, but based on everything I have heard, there is no evidence to support that swine flu can be transmitted through the consumption of pork products. Still, investors did not let this fact stand in the way of selling Zhongpin (HOGS), the $231 million (market cap) Chinese producer of pork and pork products. HOGS fell 6.2% yesterday on the second highest volume session since last July in what was clearly a case of guilt by association.

Options traders, however, reacted in a different fashion. The graphic below, courtesy of, shows that while options activity spiked dramatically, most of the action was in calls, which was running at about twice the rate of put volume yesterday. Also, implied volatility (not shown) more than doubled.

Obviously there is a great deal of uncertainty surrounding swine flu – and a fair amount of misinformation being circulated. There is no doubt that eating pork products is unrelated to the spread of swine flu, but that does not necessarily mean that pork products and stocks such as Zhongpin will be shunned and suffer real declines.


Disclosure: Long HOGS at time of writing.

Sunday, April 26, 2009

Chart of the Week: Continuing Jobless Claims

With all the hoopla over some of the green sprouts that are appearing in the economic garden and the knowledge that it has been four weeks since initial jobless claims peaked at a level just below the October 1982 record, I wanted to provide a picture of continuing jobless claims that is very different from the more widely reported initial claims data.

The chart of the week below tracks continuing jobless claims since 1967. Whereas initial jobless claims (red line) are currently just below the 1982 record levels, continuing claims (blue line) have spiked to levels that dwarf 1982 levels by more than 30%.

Initial jobless claims are indeed an important concern, but right now the bigger problem is that existing jobless workers are having an extremely difficult time finding new work. Unfortunately, after setting new records for 12 weeks in a row, the trend in continuing claims shows no sign of letting up at this time.

[source: Department of Labor]

Friday, April 24, 2009

XLY and XHB Move Above 200 Day Moving Averages

Two important ETFs, XLY (consumer discretionary) and XHB (homebuilders) have moved above their 200 day simple moving averages today for the first time since early October.

Among other important indices and ETFs that are closing in on their 200 day SMAs are the NASDAQ-100 index (NDX), semiconductor index (SOX) and emerging markets ETF (EEM).

If the current bullishness holds, we may see widespread moves above the 200 day SMA – and the possibility of renewed buying interest…or an opportunity to take profits.

I am cautious as the SPX approaches 875, but am not interested in a substantial short position until there is some sort of bearish momentum.

Thursday, April 23, 2009

The New VIX Macro Cycle Picture

Since the dawn of VIX data, which extends back to 1990, the VIX has shown a tendency to move in cycles of 2-4 years that I refer to as VIX macro cycles.

The chart below shows six distinct VIX macro cycle periods of declining, rising or flat volatility. For now I have assigned a letter to each period, but at some point I may go back and name each of them, describe the various influences on volatility during the period and set about establishing a fundamental and technical basis for classification.

My goals for today are much more modest. For the moment I am establishing January 2007 to November 2008 as the official endpoints of the most recent period of rising volatility. As of December, we are in a new VIX macro cycle. While the first few months of this new volatility era showed a dramatic decline in volatility, I suspect that volatility will flatten out relatively soon, as was the case when the volatility spikes of 1994 and 1998 ushered in a period of relatively flat volatility.

Note from past volatility spikes that the initial snap back to lower levels of volatility typically last from 4-6 months after peak volatility. If this pattern were to be repeated once again, then I would expect volatility to put in a new bottom in no more than the next 2-3 weeks.

Guessing where volatility will find a new plateau is not easy, but for now I am establishing a provisional bottom of 30. Ultimately, I would not be surprised if I move the bottom down to somewhere in the 25-27 range, but there is a lot of work to be done before that much fear and volatility can be driven from the collective investor psyche and markets are able to establish a degree of comfort with the various financial and economic institutions that will shape the major events and policies of the next few years.

[source: StockCharts]

Wednesday, April 22, 2009

How to Create Your Own Portable VXV

I recently received a question from a reader who was looking to create a homemade version of the VXV that he could apply to the Nifty (formally known as the S&P CNX Nifty), which is an index of 50 large capitalization companies on the National Stock Exchange of India. Specifically, the reader wanted to know if it would be possible to use a 93 day moving average of the India VIX to create an index that would be analogous to the VXV.

Actually, VXV ignores all historical volatility readings and utilizes implied volatility instead. It is the blending of implied volatility for the options from the months that are closest to 93 days into the future.

Refer to the graphic below and I will create a “quick and dirty” version of VXV that can be used on any underlying that has options. The example here is for the SPX, but the same process can yield a VXV proxy for any underlying.

The steps are as follows:

  1. Determine the two options expiration months whose time to expiration is closest to 93 days (the term for the VXV). In this case we are using July, with 85 days until expiration and August, with 120 days until expiration. Of course once each month there will be one month with exactly 93 days until expiration.

  2. Determine the last close in the SPX and the series immediately above and below the last close for each of the two months. Here the last close is 843.55. For July, the series for the calculations are 840 and 850. For August, we use 825 and 850.

  3. Determine the implied volatility levels for both the puts and calls for the relevant series for each of the two months. These are highlighted in red in the optionsXpress graphic below.

  4. Interpolate the implied volatility for the SPX close from the two July calls (A), July puts (B), August calls (C) and August puts (D). In this case the interpolation is done by assuming the proportions for the SPX close are the same as they are for the implied volatility values. For example:
    A = 31.1 + (6.45/10)*(31.3-31.1)
    A = 31.229

  5. Now that we have implied volatility levels for the SPX close, we need to average these across both puts and calls for each month. July = (A + B) / 2 and August = (C + D) / 2

  6. Finally, interpolate the July and August results from the step above to estimate 93 day implied volatility. The easiest way to do this is to start with the nearer month and then add the appropriate fractional portion of the later month that lifts the blended average to 93. The approach is analogous to the interpolation above and yields and equation that looks like this:
    VXV = [(A + B) / 2] + [(93-85)/(120-85) * ((C + D) / 2) – ((A + B) / 2)]

This is not the same approach that is used by the CBOE, which is more complex and is detailed in the CBOE S&P 500 3-Month Volatility Index Description. This quick and dirty variant can be calculated quickly and is portable across any underlying with options, including the Nifty.

[source: optionsXpress]

Tuesday, April 21, 2009

Lost in Translation: VXX and VXZ

Partly based on some thinking I laid out last week in Some VIX Milestones…and a Prediction, I was fortunate to be long VXX, the iPath S&P 500 VIX Short-Term Futures ETN, going into yesterday’s session.

VXX notched a nice one day gain of 7.40%, but this was less than half of the 15.44% gain in the VIX. On the other hand, VXZ, iPath S&P 500 VIX Mid-Term Futures ETN, which targets VIX futures approximately five months out, moved a mere 3.41%, less than half of VXZ. As shown in the chart below, VXZ’s jump did not even match that of the 4.28% drop in the SPX.

All things considered, these are about the percentage moves relative to the VIX that one should expect. I have previously discussed the relative juice factor in VXX Data Now Painting an Accurate Picture and elsewhere, but apparently not everyone has internalized this information yet. Further, if you follow any of the term structure discussions here, the volatility predictions as a function of months into the future is a recurring theme.

With almost three months of data to draw upon, VXX is now averaging close to 50% of the daily move in the VIX and VXZ is averaging approximately 20% of the daily move in the VIX. The bottom line is that if you are looking for the type of moves generated by the cash VIX, your best bets are VIX options, VIX futures or a 2x leveraged play on VXX.

Personally, I find VIX options to generally be the most attractive way to trade the VIX, given their liquidity and the flexibility inherent in structuring a wide range of options positions.

[graphic: VIXandMore]

Disclosure: Long VXX at time of writing.

Monday, April 20, 2009

Commercial Real Estate Problems Piling Up

Though it gets little in the way of airplay on the blog, real estate happens to be one of my favorite asset classes. It is volatile, can be highly leveraged and also provides what I call “use value,” meaning that it is not necessarily just a piece of paper you hope will appreciate, but can also be tangible property that you can get some enjoyment out of. For the same reason, I would much rather have a Miró hanging on my wall than an investment in an art ETF.

Getting back to real estate, I theorized in Waiting for the Next Shoe to Drop that either credit card debt or commercial real estate would be the most likely candidates to usher in the next leg of the financial crisis.

Moody’s recently reported that the U.S. credit card charge-off rate rose to a record 8.82% in February and noted that they expect charge-offs to hit a peak of 10.5% during the first half of 2010.

The ticking bomb of commercial real estate may have even more severe consequences as commercial real estate prices continue down over the course of the next few years. A week ago, Fil Zucchi did an excellent job of explaining the problems in commercial real estate at Minyanville in A Commercial Real Estate Comeback? and today he is back with a follow-up piece, Ten Reasons Why Commercial Real Estate Won’t Rebound.

There are many ways to play real estate. The double ETFs, URE (+2x) and SRS (-2x) are a good place to look for trading vehicles. For non-leveraged plays, IYR offers the best liquidity and an active options market to boot. Given the strength of the recent bounce in real estate stocks (more than 50% off of the recent bottom, as the chart below shows), I would favor the short side at least until I get a better sense of how the commercial real estate story will unfold.

[source: StockCharts]

Disclosure: Short IYR at time of writing.

Sunday, April 19, 2009

Chart of the Week: Capacity Utilization Sets New Low

I have been bullish since March 5th (SPX at 687; Intermediate Bottom Potential Is High), but a number of factors have turned my bias back to the bearish side in the course of the past few days.

Apart from some technical indicators which suggest equities are overbought at present, there has been a recent wave of economic data, much of it swept under the rug, which suggests that bullish headlines may soon be on the wane. The news spans housing starts to foreclosures to credit card charge-offs to retail sales and industrial production. Frankly, none of it looks promising.

Joined at the hip to the industrial production report is capacity utilization data. Essentially, this statistic measures how much of the national production capacity is being used and how much is sitting idle.

This week’s chart of the week looks at the full history of total capacity utilization in the United States, based on data available from the Federal Reserve. Total capacity utilization for March was just 69.3%. This is the lowest number in the history of this statistical series, which dates back to 1967. While not shown in the graph below, manufacturing capacity utilization fell to 65.8%, which is the lowest number since records were first gathered in 1948.

In terms of interpreting the capacity utilization data, it is probably best to think of the number as a broad measure of demand relative to existing infrastructure. Of course the current record low numbers reflect a historic weakness in demand. Capacity utilization is also a strong predictor of inflationary and deflationary pressures. With so much slack in the system, deflationary pressures are sure to increase as prices get slashed in order to offset the high fixed costs of so much idle productive capacity.

In addition to the current bad news, there are some complicating factors which may make it difficult to reverse the recent trend. Looking ahead, a stronger dollar and weaker consumer does not bode well for future production data – and should raise new concerns about the possibility of deflation.

Industrial production may steal most of the headlines, but capacity utilization is an often overlooked important piece of the economic puzzle.

[source: Federal Reserve]

Friday, April 17, 2009

VIX:VXV Ratio Down to 0.92

With the SPX at 873, it looks like a good time to get short to me...

Thursday, April 16, 2009

Some VIX Milestones…and a Prediction

It was an interesting trading day not matter how you slice it. When all was said and done the SPX had its highest close since February 9th and moved as close as it has been to its 200 day simple moving average (SMA) since September 26th of last year.

The VIX hit some interesting milestones as well. Today’s close of 35.79 was the lowest close since that same September 26th and the 10 day SMA of the VIX is under 40 (as of yesterday) for the first time since the beginning of October. Elsewhere in the VIX family, the iPath S&P 500 VIX Short-Term Futures ETN, VXX, is now at its lowest level (94.91) since its January 30th launch. Finally, the 10 day historical volatility in the SPX is at a 10 week low (31.18) and 20 day HV just slid below 40 for the first time in 6 weeks.

While the numbers above represent an incremental change in volatility, they also reflect a sea change in investor outlook. Just a few weeks ago it was widely believed that all the banks were insolvent, the economy was not going to turn around until 2010 and if we were lucky, the housing market might bottom before the end of the year.

A flicker of hope here and a flicker of hope there and now suddenly some of the worst case scenarios are being discarded. Perhaps it is just a case of the slowing pace of economic deterioration, but there is always the possibility that things have already started to turn up. After six months of bad news getting worse and worse news morphing into terrifying, even just being able to set aside a couple of the potential disaster scenarios seems to be cause for celebration. But, are the celebrations premature?

Volatility is notoriously difficult to predict, but my personal forecast is for the recent decline in volatility to drop to no lower than the 30-32 level before flattening out, perhaps just in time to meet the 20 month SMA in the (monthly) chart below.

If you have not looked into or traded VXX, next week might be a good time to think about hedging or speculating on an upside move in volatility with this VIX ETN.

[source: StockCharts]

Wednesday, April 15, 2009

Straddles vs. Iron Butterflies

After receiving several questions and comments regarding yesterday’s VIX Expiration Straddles and a related prior post, A VIX Butterfly Play, I realize that I skirted a fundamental options issue that I should probably have placed more emphasis on: unlimited vs. limited risk.

The issue centers around a key concept in trading options: is the maximum loss on a position limited? In other words, at the time the position is opened, is it possible to define, in dollar terms, the maximum loss and the price points at which this loss will occur?

The question can also be addressed in graphical form.

In the profit and loss graph below, courtesy of optionsXpress, I have replicated a trade that is similar to the straddle trade highlighted in VIX Expiration Straddles, except that it uses May options.

If the trade has unlimited risk, such as is the case with the short straddle below, the profit and loss graph will show diagonal lines at the extreme left and right side of the x-axis.

By contrast, it is possible to augment a short straddle position by buying insurance to protect against unlimited losses in the form of an equal amount of long calls (known in some circles as “buying the wings.”) The result is an iron butterfly, with the “wings” limiting losses.

The graphic below shows the same trade as the short straddle above, but with the additional purchase of out of the money puts and calls. Notice how the new wings are the horizontal lines that reflect limited losses of $440 in this position.

The wings are particularly important in the event of extreme moves. In the short straddle, every dollar move in the VIX above 45 results in an additional $1000 loss. The iron butterfly, however, limits losses at 40, so the VIX can spike as much as it wishes over 40 without impacting the bottom line. The same dynamics are at work were the VIX to plunge dramatically.

Note also the cost of the insurance will reduce the maximum potential profit (which falls from $5510 to $2060) by 63% and also shrink the price range in which the trade is profitable (from 31.99 – 43.01 to 35.44 – 39.56) by the same 63%.

It may be helpful to think of the cost of buying the wings as the price of insurance to limit risk. Most traders prefer to pay the insurance premium and sleep better at night, but there are those who prefer to forego the wings and hope to avoid a disaster. This type of approach can be effective in the short-term, but over the long haul is an excellent way to lose all your trading capital.

For the record, the same relationship described above with respect to straddles and butterflies is analogous to the relationship between strangles and condors.

[graphics: optionsXpress]

Tuesday, April 14, 2009

VIX Expiration Straddles

With less than an hour left before today’s trading session comes to a close and the April VIX options can no longer be traded, this seems like as good a time as any to mention a pure overnight volatility gamble: the VIX expiration straddle.

I have difficulty calling this trade anything other than a speculative gamble and am certainly not recommending it, but there are some who love this type of trade.

As outlined in the optionsXpress graphic below, the VIX is at 37.61 as I type this, just 0.11 above the 37.50 strike. In the example indicated in the graphic, selling 10 April VIX 37.50 calls and 10 April VIX 37.50 puts nets $1250. If the VIX settles at tomorrow’s opening at 37.50, this is the maximum gain. As the profit and loss table shows, break even is at 36.25 and 38.75. A loss comparable to the maximum profit of $1250 will be realized at 35.00 and 40.00. If the VIX settles below 35.00 or above 40.00, then the losses will be even more significant. For long positions, the numbers are reversed.

That is pretty much the trade in a nutshell.

Anyone making this trade should be aware that there are several important economic releases before the open tomorrow, including the March CPI data, March industrial production and capacity utilization, and several others. In addition, there is a fairly large slate of earnings due out after the close today and before the open tomorrow. In short, a lot can happen overnight.

Still…if you think the VIX will settle between 36.25 and 38.75, a VIX short straddle is one way to put that idea into action.

It is also important to keep in mind that most options players who are looking to make this trade will likely be doing so several weeks before expiration and close the position out prior to the last trading day...but there are others like like the overnight approach.

For two related VIX expiration options plays, check out:

[source: optionsXpress]

Monday, April 13, 2009

VIX High or Low? It Depends…

The question of whether the VIX, which closed at 36.53 on Thursday, is high or low, depends a great deal upon the historical backdrop one uses to make the comparison.

In the chart below, I have represented 36.53 as a percentile based upon prior VIX readings of 10 days, 20 days, 50 days, etc. going back all the way to the beginning of VIX historical data in January 1990. The chart paints an interesting story. As the VIX is the lowest it has been in more than 100 trading days, Thursday’s close puts it at the 0.0 percentile level for all periods up to and including 100 days.

If, however, you place the current VIX in the context of 20 years of historical data going back to 1990, suddenly the VIX is in the 95.8 percentile. As the chart shows, even looking at three years of historical data puts the VIX at an 82.4 percentile level.

Finally, one year of data suggests that the VIX is in the 47.4 percentile, right in the middle of its recent historical range.

So…the VIX is both extremely high and extremely low in historical terms, depending upon the lookback period. For short-term trades, I find the 10 day and 20 day data to be most useful in helping to create profitable mean-reversion setups, though long-term investors should probably look at the VIX relative to a multi-year history as being the most relevant indicator of the future direction of volatility.

[source: VIXandMore]

Saturday, April 11, 2009

Russia Leading the BRIC Rally

The last time I checked in with the BRIC countries, four months ago, the issue de jour was BRIC Update: China a Leader or an Outlier? At that time, China was starting to move impressively off of an October bottom and Russia was a notable laggard.

As the chart below shows, in the five weeks since the U.S. stock indices have bottomed, it is Russia (RSX, red line) that has been the strongest performer, followed by India (EPI, blue line), with Brazil (EWZ, gold line) and China (FXI, black line) bringing up the rear.

I watch these relationships closely for a number of reasons, not the least of which is to determine how well the group as a whole is performing, if any particular country is separating itself from the pack, whether commodity producers or consumers are in favor, etc.

Part of the reason Russia has bounced more than its BRIC counterparts is that Russia suffered disproportionately in the recent bear market. In the nine months from June 2008 to February 2009, the RSX Russian ETF lost more than 82% of its value. The last month, however, has seen some notable improvements. Russia’s credit default swaps, for instance, which reflect to the cost to insure the country’s debt, have improved from 694 to 412 in the last four weeks as the outlook for that country’s sovereign debt has improved dramatically.

Going forward, country-specific trends may continue to dominate, but I suspect the relative performance of Russia and Brazil will say more about improvements in the commodities market as a whole than about the plight of a particular national economy.

[source: BigCharts]

Friday, April 10, 2009

Chart of the Week: VXV and Systemic Failure

When it comes to the chart of the week, anything goes. Now it its six month, this regular feature can highlight anything from an important economic data release to interest rates, bonds, index performance, market internals and even my strange and unusual ratios. My intent has been to keep volatility in the loop, but generally cast a wide net each week.

This week I am focusing on volatility, but probably not a measure that many readers pay attention. Specifically, I am speaking of the VXV. This index is essentially a 93 day version of the VIX, but for those who are interested in further digging, a good place to start is with my December 2007 Thinking About the VXV.

One reason I think the VXV is worth following is that I believe it gives a better perspective on structural volatility and systemic risk than its short-term counterpart, the VIX. For more on this subject, I encourage readers to check out my November 20, 2008 post, The VXV and Extreme Structural Volatility Risk.

All this brings us to the chart below. The quick takeaway is that according to the VXV, structural volatility and systemic risk peaked on November 29th and has been in a decline ever since, as the dotted blue descending triangle reflects. I have also included three vertical red lines to show significant market bottoms. The first two generated significant VXV spikes and were eventually violated. The most recent bottom, which resulted in the SPX hitting 666, is shown with a dashed vertical red line. An important feature of that bottom is that the VXV did not spike, suggesting that there was no increase in systemic risk – perhaps part of the reason why the 666 bottom has held.

Finally, note that as of Friday (red circle), the VXV has dropped to levels not seen since the first week in October. The key takeaway: systemic healing is continuing and the risk of systemic failure is diminishing. When the VXV is able to make it back below 30, I suspect this will be an indication that systemic risk is once again at a manageable level.

[source: StockCharts]

Thursday, April 9, 2009

The Persistence of Volatility

I have often thought that Salvador Dali’s The Persistence of Memory, with its famous melting clocks, should be the official painting of all options traders, for if there is anything that distorts time, it is the wild permutations of the positions and mind of an options trader.

With the VIX closing at 36.53 today, the lowest close since September 26th, volatility and time seem to be warping once again. After weeks of bouncing off of the 40 level, the VIX appears to finally be headed in the direction of pre-Lehman levels.

The six and a half months of persistent volatility has me thinking that it is a good time to compare the volatility trends of 2008-2009 with the only other period of high implied volatility on record, the 1987 crash.

The chart below shows that VIX spikes from 1987 spent 86 consecutive trading days above 30 and roughly a month over 40, 45 and 50. In contrast, the 2008-09 financial crisis witnessed three months (63 trading days) in a row with the VIX above the 40 level and an impressive 134 and 144 days above the 35 and 30 levels, with those records still ongoing. This is not to say that the 144 day string is getting too long in the tooth, only that we are in well into uncharted territory when it comes to implied volatility.

Of course there are no implied volatility data going back to the Great Depression, but the 30 day historical volatility, a reasonable proxy for the VIX, was able to remain above the 30 level for 16 long months from September 1931 to January 1933. If the VIX stays above 30through Memorial Day, that will mark the halfway point of the 1931-1933 record.

[source: VIXandMore]

Wednesday, April 8, 2009

Waiting for the Next Shoe to Drop?

There has been a lot of speculation about which corner of the economy is likely to implode next and start to write the next chapter in the current financial crisis. Credit card debt and commercial real estate are two of the most frequently cited potential culprits, but lately Eastern European banks have been under great stress, while credit default swaps for Romania, Bulgaria and Hungary have been on the rise.

I did not realize how strong the undercurrent of fear was until I ran Today’s Jump in the VIX on Monday evening. From the various public and private comments, it is clear that there is a strong contingent of veteran investors who anticipate not only that the next shoe will drop soon, but that the fallout will be at least as bad as what we experienced during the October-November peak of the crisis.

While I am not ruling out anything at this stage, I do not see the VIX spiking above 60 in the near future, nor do I even see a VIX above 50 as a likely scenario.

Last Friday, the SPX had its highest close since the 666.79 “devil’s bottom” low of March 6th. From Friday’s 842.50 close to Tuesday’s close of 815.55, the SPX fell 3.2%. During this same period, the cash VIX gained just 1.7%, moving up from 39.70 to 40.39. In the chart below, however, one can see that even thought the cash VIX rose, the volatility index for SPX options in April, May, June, July and September actually fell, with volatility for the April expiration showing a 12.5% drop in the VIX, May volatility dropping 4% and the June through September strikes show a volatility decrease on the order of 0.9%-1.6%. In other words, expectations for volatility – and presumably fear and uncertainty – for the balance of the year continue to point to improvement.

Of course, there is always a group of traders who get fearful when the VIX fails to measure what they believe is an appropriate level of fear. This group, whose concern I can sympathize with from time to time, will undoubtedly see an indifferent VIX as a reason to be even more concerned about the future.

For now at least, the VIX term structure points to increasing investor confidence in the markets and a decreasing concern about the possibility of gravity commingling ominously with oversized footwear.

[source: CBOE, VIXandMore]

Monday, April 6, 2009

Today’s Jump in the VIX

Lately it seems like I am the only one who is not talking about the VIX. I find it particularly ironic that many of the same people who were pounding the table saying that the market could not bottom unless there was another dramatic VIX spike and high volume capitulation are now insisting that the markets cannot rally from current levels until the VIX continues down. I suspect these pundits will end up going 0 for 2 in their predictions.

For the record, at the very moment the SPX formed the “devil’s bottom” of 666.79 on March 6th, the VIX was at 51.65, which was not even the high for the particular day. By the end of the day, the VIX was down to 49.33 in what looks in retrospect like a classic stealth bottom.

So what is driving the VIX right now? In a previous post, I opined that a simplistic conceptual model of the VIX is one which “incorporates incremental changes in uncertainty and fear on top of recent historical volatility.” Many of the common measures of historical volatility (10, 20, 30 and 50 day) show that historical volatility in the SPX topped in the middle to latter portion of March. Since the 7.08% jump in the SPX on March 23rd, trading has been relatively subdued from a volatility perspective. As that 7.08% jump as well as the 6.37% and 4.07% jumps from March 10th and March 12th begin to scroll off the lookback window, historical volatility numbers should begin to lead the VIX back down.

As far as fear and uncertainty are concerned, the fear of a global systemic bank failure seems to be receding, while concerns about a deepening global recession are lingering and still rising in some quarters. The G-20 meeting underscored the willingness of leaders of the world’s largest economies to coordinate their activities, even if they cannot agree on the details of those coordinated efforts.

Finally, we are in a news cycle lull this week, but earnings season officially kicks off with Alcoa (AA) reporting tomorrow.

The bottom line is that current levels of the VIX are in line with historical volatility readings and changes in the macroeconomic landscape. The fear component of the VIX is clearly on the wane, which should mute any VIX spikes. On the other hand, historical volatility needs to continue to decline and the VIX term structure (which is based on SPX options) and VIX futures need to soften somewhat before the VIX can reasonably be expected to start trading in the 30s on a regular basis.

Many analysts have a tendency to rely too heavily on charts when looking at the future of the VIX. While charts can provide some useful information and it is nice to know that the VIX has recently moved below its 200 day moving average, sometimes putting the VIX in the proper geopolitical and macroeconomic context is a more valuable approach.

So…I think the VIX is about where it should be right now and stocks can resume their move up without the VIX being required to plummet. In fact, if the bulls continue to keep the upper hand, expect the VIX to decline in a decidedly gradual fashion.

Finally, the VIX jumped 3.1% today, while the SPX lost 0.83%. That -4x move is typical of the VIX, but not on Mondays, when ‘calendar reversion’ usually means the VIX jumps about 1.5%. Add to this the 1.53% that the VIX fell during the 4:00 – 4:15 p.m. ET index trading portion of Friday’s session and one could make the argument that the VIX barely moved at all today relative to the SPX.

For another perspective on the recent movements of the VIX, I recommend More Ways to Look at Volatility from Daily Options Report.

Sunday, April 5, 2009

Chart of the Week: The Resurgent NASDAQ-100

Technology is back and large cap technology is helping to lead the recent rebound in equities.

Even after a four week rally, 2009 has been mostly a sea of red. In fact, the two headline indices, the Dow Jones Industrial Average and S&P 500 index, are down 8.65% and 6.73% so far in 2009. Neither large caps nor small caps are performing particularly well, with the large cap S&P 100 (OEX) down 8.27% and the small cap Russell 2000 (RUT) down 8.67% year to date.

The technology-heavy NASDAQ has been a very different story, with both the NASDAQ composite index (+2.84%) and NASDAQ-100 (+8.63%) in the green.

In the chart of the week below, I have highlighted the NASDAQ-100 index (NDX), which closed at its highest level since early November on Friday, following a strong earnings report and increased guidance from Research in Motion (RIMM). The NDX is a weighted index of the largest 100 companies in the NASDAQ, as measured by market capitalization. As such, the largest weightings read like a who’s who list of large technology companies: Microsoft (MSFT); Google (GOOG); Cisco (CSCO); Apple (AAPL); Oracle (ORCL); Intel (INTC); Qualcomm (QCOM); etc.

Whether or not the resurgent NDX can continue to rally and retrace its steep drop from September and October will go a long way toward determining if the broader markets will be able to gain enough momentum to also finish 2009 in the green.

[source: StockCharts]

Thursday, April 2, 2009

Calculating the Implied Volatility of the VIX

Earlier today, a reader had an excellent observation and question regarding the implied volatility of the VIX:

“I noticed that the IV for ATM July options is 50 while the VIX itself is 42 right now. That seems crazy to me since the IV for the VIX is a second derivative and should be much more than the VIX itself…”

The problem with most data sources is that they assume the cash/spot VIX is the underlying for VIX options, instead of using VIX futures, which more accurately approximate the underlying for VIX options (which is technically a variance swap.)

I cannot vouch for every data provider, but I believe most of the highly regarded options sites on the web use the cash/spot VIX to calculate VIX implied volatility, so the resulting calculations are distorted by the difference between the cash/spot VIX and the VIX futures.

Several options data sources have a proprietary mean implied volatility calculations that they publish for optionable securities. Perhaps the best known of these is the “IV Index mean” from After today’s close, the iVolatility VIX IV index mean was 61.38. The International Securities Exchange has a similar calculation that uses the same name. Today the ISE’s VIX IV index mean closed at 64.98.

Thinkorswim calculates an IV for each month. For April, they have the VIX IV at 85.71. Doing a little interpolation on the optionsXpress site, I get a VIX IV for April ATM options of 77.12.

Without knowing the details behind the models that generate these VIX IV calculations, I cannot vouch for the integrity of any of the VIX IV outputs. I would love to find a source that calculates the implied volatility of the VIX using VIX futures as the underlying. My guess is that none of above four numbers takes this approach. If anyone is aware of a source that publishes VIX IV calculations based on VIX futures, I would certainly be interested in hearing more about it. Until then, my working assumption would be that all the VIX IV data you get from your data provider is invalid and based on the cash/spot VIX.

Wednesday, April 1, 2009

The Options Opportunity Matrix

Maybe I spent too much of my former life in consulting, where 2x2 matrices seem to grow wild on PowerPoint slides, but I have always found that a matrix is a useful way to help compare and contrast the tension between conflicting yet sometimes complementary ideas.

I mention this because I have recently fielded several questions about my options trading approach. In thinking about how I might want to discuss the subject, I realized that I have unknowingly been carrying around a 3x3 options matrix in my head for the past few years. Since I have yet to encounter anything like it, I thought this might be a good time to give the matrix a name and use it as a prop to discuss options strategies.

The graphic below, which I am calling the Options Opportunity Matrix, lays out a portion of my approach.

Let me take a minute to explain the graphic a little. When most investors consider whether or not to invest in a stock, they have an opinion about the future price of the stock. Their price forecast is represented by the Y-axis and is color coded for easy reference. The upper most row is green (3A-3C) to reflect an anticipated price appreciation; the lower row is red (1A-1C) to indicate a bearish price forecast; and the middle row is shaded gray (2A-2C) to reflect those instances in which investors expect a stock is not likely to move significantly up or down. The majority of investors live their lives in the top row, thinking only about those stocks that have a chance for significant price appreciation.

While options investors have a strong interest in price changes, they are also particularly concerned about changes in volatility. Here the columns and textures reflect opinions about future volatility, with column 1A-3A indicating an expectation of declining volatility, the more textured 1B-3B accounting for no change in volatility, and the highly textured 1C-3C reflecting an increase in volatility. Options traders are particularly interested in changes in volatility, both up (1C-3C) and down (1A-3A), so they are very comfortable initiating new positions when their opinions about a particular security fall into either of the outer columns.

In fact, an options investor that has an opinion about the direction of price and volatility should be happy trading in any of the nine scenarios on the matrix, and in so doing utilizing different strategies for each box. Multiple strategies are appropriate for each of the nine situations, but it is only important for the investor to be comfortable with one for each box. Frankly, some options investors may choose to focus on only one of the nine scenarios and can make a nice living with a narrow specialty.

In future posts on this subject, I will discuss the Options Opportunity Matrix strategy approaches in much greater detail, but in this first installment I want to make sure that the abbreviations are clear. To interpret the matrix, consider a forecast for an increase in price and an increase in volatility. Using the icons and/or the color and texture overlays, note that cell 3C recommends a long call position for this forecast. If an investor expects an increase in price, but a decrease in volatility, then cell 3A recommend selling a put. Finally, if an investor expects an increase in price, but no change in volatility, then the recommendation at 3B is to go long the underlying. Obviously, there are quite a few alternative trades, such as spreads, for each of these cells, but the basic trade is recommended here.

The matrix also identified what I call volatility trades. Long volatility trades, such as those in cell 2C are best executed when the forecast is for price to stay in a narrow range, while volatility increases. The ‘basic’ volatility trade is probably a short straddle, but my personal preference is usually for a long condor.

In the next part of this series, I will explain a little more of the logic behind the various matrix recommendations and talk about how I put the ideas behind this matrix into action.

[source: VIXandMore]

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