Sunday, May 31, 2009

Chart of the Week: Emerging Markets

One of my best trades for 2009 has been a long position in EEM, the emerging markets ETF. The chart of the week below shows that emerging markets have been consistently outperforming the S&P 500 index since the beginning or January (see ratio study at top of chart) and was one of the first major equity groups to top its 200 day simple moving average (dotted green line) in late April. While the SPX has been going sideways during May, emerging markets have continued to tack on gains, bolstered by rising prices for commodities.

I would not be surprised to see EEM finding increasing resistance at several stages in the 34-40 range, but for now at least, I see no reason to exit EEM at least until its performance relative to the SPX begins to falter.

Disclosure: Long EEM at time of writing.

Friday, May 29, 2009

Late Day Rallies, the SPX and the VIX

Today was an interesting trading day, particularly during the last hour of equity trading.

The graphic at the bottom records (in Pacific Time) the intraday movements in the VIX, which was essentially flat for all but the first hour and the last 22 minutes of trading. At 3:00 p.m. ET, the VIX stood at 30.97, down 0.70 (-2.21%) from yesterday’s close. At that same moment, the SPX was at 906.67, down 0.16 (-0.02%) for the day.

The SPX began a slow and steady rise at the beginning of the last hour of trading, with the VIX gradually pulling back. The table below captures the changes in the VIX and SPX during that last hour. Note that the VIX, whose values are updated every 15 seconds, begins to move sharply at 3:38, then creates the first of several gaps at 3:41. By 3:59, one minute before NYSE trading closes, the VIX has moved about 4.5x of the percentage change in the SPX, in the opposite direction. At 4:00 the stocks that comprise the SPX stop trading. The daily high of 920.02 for the SPX was recorded in the minute that followed, as some trade data trickled in after the bell. During the two minutes after the close, the SPX was revised down in small increments several times, before being finalized at 4:11.

While the individual components of the SPX stop trading at 4:00, SPX index options trade for an additional 15 minutes in what I like to refer as the twilight zone trading period. This can lead to some interesting VIX prints, particularly if there is a strong move in the SPX toward the end of the regular trading session or if important news breaks during the 15 minute twilight zone. What apparently happened today is that the supply of SPX options overwhelmed demand in the last few minutes of the regular trading session and carried over into the 15 minutes of index options trading. By the time the VIX was finalized, at 4:15 p.m. ET, it had fallen all the way to 28.92, a move that was 6.4x the percentage change of the SPX, in the opposite direction.
Normally, when one sees a dramatic change in the ratio of the VIX to SPX percentage moves, this is indicative of a substantial imbalance in the supply and demand equation for SPX options.

As a side note, those who are analyzing historical VIX and SPX data should be aware that the different cutoff times can occasionally lead to some unusual data anomalies.

For additional information, check out a related post on this subject from January: VIX (and VXN) After Hours.

[source: thinkorswim]

Wednesday, May 27, 2009

Using Options to Control Risk in Leveraged ETFs

Several readers noted that options on leveraged ETFs seemed like a recipe for disaster, as if no good could possibly come from piling leverage on top of leverage. While I certainly understand the sentiment, this type of thinking is typical of investors who have little or no experience in options. To the investor who is not versed in options, the options world often seems to be limited to an occasional covered call or an out-of-the-money call that is barely distinguishable from a lottery ticket – and seems to pay out just about as often.

In fact a large percentage of options traders are attracted to options because they are an excellent way to define, limit and manage risk. Yes, one can buy a put to provide protection for a long stock protection, but in the absence of owning the underlying (be it as stock, ETF, index or whatever), options traders are particularly fond of creating multi-leg options positions where the downside risk is known at the beginning of the trade and does not waver as long as the position is maintained.

Getting back to leveraged ETFs, I have reproduced a portion of the options chain for FAS, perhaps the most notorious of the Direxion triple ETFs, in the table below. With a current mean implied volatility of 126, FAS is a highly volatile ETF. FAS is so volatile that even with only 17 trading days remaining in the June calls, it is possible to sell the June 15 calls, which are 70% out of the money, for 0.05. The June 11 calls, which are 24.4% out of the money, can be sold for 0.40.

In terms of risk management, let’s say that an investor does not believe that FAS is going to rise more than 24% in the next 3 ½ weeks, so he or she decides to sell the June 11 calls, but hedge that position by buying an equal amount of the June 13 calls at 0.15. This is a bear call spread and will net $25 for each option contract, with a maximum loss of $175 per contract (not including commissions). The trade makes money if FAS expires at 11.25 or less, which means that the position can absorb up to a 27.2% gain in FAS. The trade offers odds of 7-1 ($175 to $25) and the maximum risk is defined up front and cannot change during the life of the trade.

This is but one example of how options can limit the risk of trading triple ETFs. There are many other potential examples.

The bottom line is that options trades can be structured in such a manner that they are much less risky than stock trades, even if the options are on volatile securities such as triple ETFs.

[As an aside, readers may have noticed that up to this point I have somewhat standardized on the options tools and graphics available through optionsXpress. Going forward, I will make an effort do a better job of highlighting some of the tools and content available at various other options brokers in order to illustrate some of what is available to the reader and at the very minimum, provide more visual variety.]

[source: OptionsHouse]

Disclosure: Short FAS at time of writing.

Tuesday, May 26, 2009

VIX and More Stock of the Week Selection Up 343% in 14 Months

When I launched the VIX and More Subscriber Newsletter in March 2008, I promised myself that I would reference the newsletter infrequently and continue to devote the majority of my time and effort to generate the type of charts and analysis that were not available elsewhere in the public domain.

Keeping church and state separate is not always an easy thing, but last month when a long-time friend and frequent visitor to the blog discovered that I had been publishing a newsletter for over a year without his knowledge, he expressed his surprise and some disappointment at my ability to keep the newsletter a secret.

In an effort to undo some of the secrecy, I thought I would highlight one of the weekly features of the newsletter which has become my wife’s favorite as well as the favorite of a number of readers. I call it my Stock of the Week (SOTW) ‘Sequential Portfolio.’ Calling it a portfolio may be a bit of a stretch, because the self-imposed rules state that each week the entire portfolio is invested in a single stock that is purchased at the beginning of the week and sold at the end of the week, regardless of performance. I like to think of it as an equity relay race of sorts. If one stock stumbles or tires, there is always another one to take the baton just around the next turn.

The intent of the SOTW is to highlight a single stock each week, usually somewhat off of the beaten path, which I believe is worth owning for both fundamental and technical reasons. While all positions are long-only and are limited to one week, the purpose of the SOTW is not to encourage readers to hop on a single stock and ride it for a week, but rather to generate a new idea each week that might be a candidate for further investigation and perhaps an extended holding period.

The reason I decided to post about the Stock of the Week here and now is that the cumulative return for this long-only single stock portfolio is now +343.2% since I introduced the idea in my first subscriber newsletter some 14 months ago. During that period, the benchmark S&P 500 index is down some 31.7%.

Since the SOTW has reeled off eleven consecutive winning weeks and is already up 11.1% this week as a result of as a result of a big move today in this week’s selection, Core-Mark Holding Company (CORE), I have henceforth decided to post the weekly selection after the first day of trading each week, as long as the winning streak continues.

For those who are interested, I have posted the entire history of the SOTW selections below.

Note that stock selection is not the primary focus of the newsletter. Instead, there are nine regular weekly features, as follows:

  1. The Week in Review: What Moved the Markets
  2. Market Commentary
  3. The Week Ahead: What to Look For
  4. Market Sentiment (using a proprietary Aggregate Market Sentiment Indicator)
  5. Volatility Corner (discusses the VIX and other volatility indices/products such as VXV, VXX, a proprietary Global Volatility Index, etc.)
  6. Asset Class Outlook (short, intermediate, and long-term outlook for ten asset classes)
  7. Current Investment Thesis
  8. VIX and More Focus Model Portfolios (Growth and Foreign Growth)
  9. Stock of the Week

For more information about the VIX and More Subscriber Newsletter and the 14 day free trial that I offer, check out the VIX and More Subscriber Newsletter blog.

[source: VIX and More]

Options on the Direxion Leveraged ETFs

The last time I checked in with the Direxion triple ETFs was in early February, when I asked Why Is There So Little Volume in the Most Recent Direxion ETFs? While that question did not receive a direct answer, I noted that in subsequent weeks, volume picked up dramatically in the two most volatile new pairs, the emerging markets (EDC and EDZ) and technology (TYH and TYP) ETFs.

Toward the end of February, Direxion launched another triple ETF pair, the mid cap bull (MWJ) and mid cap bear (MWN) ETFs. In mid-April, Direxion added some triple ETF bonds to the mix, with a 30-Year U.S. Treasury bull (TMF) and bear (TMV) pair, as well as a 10-Year U.S. Treasury bull (TYD) and bear (TYO) pair.

For more details on the current Direxion triple ETF lineup, check out the graphic below or visit the Direxion Shares ETF web site.

In addition to expanding the universe of available triple ETFs, Direxion has sought to address criticism of the tracking error in these ETFs by adding a “Daily” prefix to each ETF name, in order to emphasize that these ETFs are rebalanced on a daily basis and only attempt to match daily moves, not track the target indices over an extended period of time. Interestingly, anyone who visits the Direxion Shares home page is met first with, “Direxion Shares are not for everyone. Are they for you?” and a link that attempts to dissuade what they describe as the conservative investor.

One of the aspects of triple ETFs that I find has some interesting strategic implications is the availability of options. As of this week, there are now options available on all of the Direxion triple ETFs with the exception of the ones based on the EAFE index, DZK and DPK.

Needless to say, there are very few trading vehicles out there with the potential to move as rapidly as options on triple ETFs, but for experienced options traders, these options offer a great deal of potential reward, paired with commensurate risk, of course.

[graphic: Direxion Shares]

Disclosure: Long TYP at time of writing.

Sunday, May 24, 2009

Chart of the Week: Commodities and the Dollar

One of the market-moving stories of the week was a decision by Standard & Poor’s to lower their outlook for AAA-rated sovereign debt of the United Kingdom from stable to negative. This action caused ripples in the currency markets, with the dollar coming under pressure after investors such as Bill Gross of PIMCO expressed concerns about the mounting U.S. deficit and potential future risk to the AAA credit rating for U.S. debt.

By the end of the week the dollar was at a four month low against the euro and commodities were up sharply, partly because commodities are seen as an effective hedge against inflation.

In the chart of the week below, I have captured a chart of the Rogers International Commodity Total Return Index ETF (RJI) versus the U.S. dollar. The chart shows that commodities formed a bottom in mid-February and have recently attracted buying in higher volumes.

Shortly after commodities bottomed, the dollar peaked and has experienced several sharp moves down. The drop in the dollar has helped to lift prices of dollar-denominated commodities and pushed money toward commodities as a potential inflationary hedge. During the course of the past three months, commodities have had two up trending periods, each of which was followed by a consolidation period. With the dollar breaking down and in danger of testing the December support level, commodities could be preparing for another upward leg soon.

[source: StockCharts]

Friday, May 22, 2009

Big Intraday Surge in VIX While SPX Treads Water

While I tend to shy away from talking too much about intraday moves in the VIX, today has been an unusual day in the VIX.

First, for most Fridays and particularly before long weekends, you should expect the VIX to be (a little more than 1.0%) lower than usual due to what I refer to as calendar reversion, when options are repriced with the assumption of lower volatility in advance of several non-trading days.

As I type this the VIX is almost flat, while all the major indices are in the green.

What is particularly interesting, however, is how the VIX has surged since about 1:00 p.m. ET. In the one minute intraday chart below, note the steady rise in the VIX over the course of the last hour or so, while the SPX has essentially moved sideways.

The action in the VIX could portend a rocky last hour or two or perhaps indicate that traders are becoming more concerned about holding long positions over the holiday weekend. Keep an eye on the VIX – and the weakness in real estate (IYR) and financials (XLF).

[source: BigCharts]

Disclosure: Short XLF, IYR and long VIX at time of writing.

Thursday, May 21, 2009

VXX Volume Tops Million Mark as Investors Embrace New Volatility ETN

When I penned yesterday’s Record Volume in VXX, I had an inkling that the VIX-based volatility ETN might be having a coming out party soon. I did not, however, expect VXX to attract so much attention in just 24 hours.

With today’s 1,094,140 shares traded, VXX is now officially in the big leagues and is sure to be added to the watch lists of many more retail investors and find itself in the repertoire of a wider variety of hedge funds.

The chart below updates the information from yesterday’s chart and adds an on balance volume study to highlight the strength of the move off of yesterday’s bottom.

For those who may be new to VXX, it is important to keep in mind that while there is strong directional agreement between VXX and the VIX (they move in the same direction in about 6 out of every 7 sessions), VXX tends to move at only half the rate the cash/spot VIX on a daily basis. So while VXX may lag the VIX in terms of a juice factor, it is probably the best way to trade volatility if one does not wish to do so in the options or futures market.

If this almost four-month-old volatility ETN were to have a motto, perhaps it would be, “When directionally correct is good enough!”

For more information on VXX, readers may also wish to check out:

[source: StockCharts]

Disclosure: Long VIX and VXX at time of writing.

VIX:VXV Ratio Moving Toward Bearish Zone

Lately I have received quite a few requests to talk about the VIX:VXV ratio, something that I first blogged about back in December 2007, shortly after the VXV volatility index was launched.

The chart below is my standard VIX:VXV ratio chart and uses the 1.08 and 0.92 end of day closing levels as basic long and short signals. The last signal on the chart is a March 1st long signal that preceded the March bottom by a week. On April 19th the VIX:VXV ratio closed at .9276, but was below the 0.92 signal line on an intraday basis.

Yesterday, I saw some data that showed the VIX:VXV ratio below 0.92 during the trading session, but a review of the intraday chart tells me that while the VIX:VXV ratio was in the 0.9150 to 0.9200 area from about 9:50 a.m. to 10:10 p.m. ET, any lower numbers were likely to have been the result of bad prints.

For the record, while yesterday’s 0.944 close suggests a bearish bias, my reading of the ratio is that the preferred entry point for shorts positions would require waiting for a close of 0.92 or below.

[Note that while this basic interpretation of the VIX:VXV ratio sets parameters for long and short entries, it does not include recommendations about exits or how to incorporate the VIX:VXV ratio into a trading system.]

[source: StockCharts]

Disclosure: Long VIX at time of writing.

Wednesday, May 20, 2009

Record Volume in VXX

While all eyes were watching the VIX take a swan dive this morning, I failed to hear any chatter about the VIX ETN, VXX. Though admittedly not as sexy or as volatile as its index counterpart, VXX still managed to fall over 40% from its February high on the way to making a new all-time intraday low of 71.96 today, before rallying late in the session to finish the day with a gain of 1.32% and a close of 77.38.

What really got my attention, however, was today’s new record volume of 825,338 shares. Since VXX is less than four months old, traders are still getting up to speed on some of the VXX’s idiosyncrasies. Given that VXX cannot be shorted (at least in my accounts), there was very little in the way of speculative interest in this product while volatility was cratering over the course of the past 2 ½ months.

The key takeaway, however, is that today there was a record number of bets on volatility using VXX. I suspect I am not the only one who thinks we probably just saw a VIX bottom.

Today may also have been the first indication that VXX has the potential to be a superb speculative vehicle in addition to a hedging tool. With an average intraday range of almost 5% and daily change approaching 3%, VXX could even join the ranks of the triple ETFs as a preferred day trading vehicle. The VIX still has a long way to go before it becomes a staple of the trading community, but today was definitely a big step in that direction.

[source: StockCharts]

Disclosure: Long VIX and VXX at time of writing.

Tuesday, May 19, 2009

Where Will the VIX Bottom?

As I write this, the VIX is at 28.80, after making an intraday low of 28.51 earlier in the session. Since this is the first time the VIX has traded below 30.00 since the middle of September, I am finding there is a great deal of interest in and speculation surrounding where the VIX will ultimately bottom – and what the implications are for equities.

In both How Low Can the VIX Go? and The New VIX Macro Cycle Picture, I predicted that the VIX is not likely to drop below the 25-26 level – and I am standing by that prediction. Actually, in my newsletter I have been a little more precise, saying during the past few weeks that I do not anticipate the VIX falling below 28.00 “for this leg of the bull market.” Frankly, this leg looks a little long in the tooth to me at the moment, but based on the recent price action, the current phase has more of the appearance of consolidation than reversal or impending reversal.

I have weighed in on several occasions about the perils of using the full technical analysis toolbox on the VIX, largely because there is no underlying one can buy and sell, given that the VIX is really just a calculated value. For these reasons – and given the VIX’s tendency toward mean reversion – I tend to shy away from momentum indicators and oscillators when evaluating the VIX and treat moving averages and support and resistance with several grains of salt.

Let me take a minute and put a VIX of 25 into some historical context. First, the historical average of the VIX for 20 years of data extending back to 1990 is 20.12 (dotted black line in the chart below.) The mean VIX for all of 2008, which includes a relatively calm April through August, is 32.68. Looking back at the five year period of 1998-2002, which included the Long-Term Capital Management debacle and the end of the 1990s bull market, the average VIX during this period was 25.27. Current data show S&P 500 historical volatility for the 10, 20 and 30 day lookback periods at 30.88, 27.24 and 30.53, respectively.

The bottom line: 25.00 is a low number for a volatile period.

The VIX may be better analyzed in a macroeconomic and geopolitical context than in terms of technical analysis. Ultimately, the VIX is only rarely a fear index. Most of the time, the volatility index is more accurately a measure of uncertainty or investor anxiety. With the bank stress test results behind us, concerns about structural volatility and systemic risk are now receding and being supplanted by lower anxiety concerns that I like to refer to as event volatility. Sure, the economy may have another significant misstep ahead, but talk of wholesale bank nationalization and the prospect of 15% unemployment have been replaced by discussions of green shoots, bottoming and recovery.

[As an aside, for awhile now I have been thinking about constructing something akin to a Beaufort scale for volatility so we can put absolute measures of volatility into a broader context.]

Regarding the current volatility environment, while confidence and liquidity are returning to the markets, keep in mind that for many investors, the financial and psychological scars are still in the healing process. As long as events and markets continue to improve, that healing process will continue. Should events take a sudden turn for the worse, however, I would expect to see volatility spike dramatically in a case of echo volatility, much like what I described in What My Dog Can Tell Us About Volatility.

In the absence of another spike in volatility, I would also expect to see a dramatic decline in the rate that volatility is decreasing, as we begin to approach a floor in volatility. Even as fears dissipate, there is still uncertainty about the strength of the recovery in addition to the normal uncertainty about the direction of the economy and the markets that would be associated with a period of relative market calm.

Historical volatility, therefore, should provide a volatility floor and with historical volatility currently unable to drop below the low to mid-20s, we should begin to see evidence of that volatility floor shortly. I have seen some investors call for the flood of liquidity to push the VIX under 20. I just don’t see it, at least for now. There is the possibility that stocks enter into an extended period of range-bound trading that brings volatility down to the low 20s, but I would be surprised to see a sub-20 VIX by the end of the year.

In 2007, the VIX ended the year at 22.50. While my crystal ball generally does not extend more than a month or two, my best guess is that we see the VIX in the 22.50 to 25.00 range at the end of 2009.

[source: StockCharts]

Monday, May 18, 2009

VIX Touches 30.00, Settles at 30.24

Today the VIX stood at 30.02 as the NYSE regular session closed at 4:00 p.m. ET, then ticked down to 30.00 just after the close and inched back up to 30.24 by the time the index trading session closed at 4:15 p.m.

The close was the lowest for the VIX since September 12th, which was the Friday just before Lehman Brothers declared bankruptcy.

All told, the VIX has now closed above the 30 level for 170 consecutive trading days. This far surpasses the previous record of 49 days in a row from 1998 as well as the 47 day string of 30+ closes from 2002.

About the only useful historical comparison for extended volatility comes from 1987-1988, where data reconstructed for the VXO (‘original VIX’ calculations) show that the ‘original VIX’ would have remained above the 30 level for 86 consecutive days – about half of the current period of heightened volatility.

To put the 30 level in the VIX in a different perspective, it may be helpful to consider that from March 2003 to August 2007, the VIX did not close above 30 at all. From April 2003 to August 2007, the VIX failed to even reach the 30 level on an intraday basis.

Finally, just for grins, 2001 is the year with the current highest low water mark for the VIX for an entire calendar year. The low VIX for 2001? Just 18.74.

I will have some thoughts on where the VIX might range for the balance of 2009 tomorrow.

In the interim, for more on volatility during the 1987-88 period, check out The Persistence of Volatility and Volatility History Lesson: 1987. For more on the VXO, including how the index would have acted during in the wake of Black Monday, try VXO Chart from 1987-1988 and Explanation of VIX vs. VXO.

[source: StockCharts]

Two Blogs to Get Me Caught Up

Some personal business has kept me away from the markets for the better part of a week and last night I found myself with the daunting task of getting caught up with what has been going on in the economy and in the markets.

Much to my amazement, I believe I can get a great deal out of looking at just two blogs: Abnormal Returns and Cobra’s Market View.

Admittedly, calling Abnormal Returns a single blog is stretching the definition a bit, as the folks at Abnormal read just about everything written on the markets and assemble a list of the best of the best on an almost daily basis. I have no idea how many articles are left on the cutting floor, but the ones that make the final links list always give me a lot of ideas to contemplate.

Whereas Abnormal Returns covers the entire economic landscape and a wide variety of perspectives, Cobra’s Market View takes a focused and highly personal approach. Yong Pan’s focus is on technical analysis. He summarizes much of his thinking in his blog, doing so by drawing upon a wide variety of superbly crafted and annotated charts. Better yet, those yearning for more information behind his thinking can always check out the 89 (!) charts Yong Pan maintains in his StockCharts public list.

I have 300 feeds that I try to read every day. When I am away from the markets for several days and need a quick update, I am amazed by how much ground I can cover just by reviewing the two blogs above.

Of course, if I wish to see what I would have written had I been blogging, I can always mosey on over to the Daily Options Report...

Sunday, May 17, 2009

Chart of the Week: Retail Sales

I usually try to make sure that the chart of the week is a chart that tackles a subject I have not seen discussed to the extent I believe it deserves or presents some new material to shine a different light on the subject.

Since I have been out of pocket for the last five days or so, it is possible that others have beaten the subject of retail sales to death during this period. Even if this is the case, I have no problem with a chart of retail sales pinch hitting for this week’s chart of the week, as I believe that the April retail sales data are a microcosm of the larger economic picture. In a nutshell, the retail sales data serve as a reminder that while things may have improved somewhat from March, for the most part, the economy is still as weak as it has been in at least three decades, probably a lot longer.

The graphic below shows the percentage change in retail sales from the year ago period. Are things improving significantly or are we just starting to scrape along the bottom? It looks as if it will take at least another 2-3 months of data before we can begin to answer this question properly.

[source: Federal Reserve Bank of St. Louis]

Thursday, May 14, 2009

Lagging Semiconductor Index Suggests Caution

Last Wednesday, the NASDAQ-100 index (NDX), which had been relatively weak compared to the SPX, put in a top and began to decline. The weakness in the NDX was one of the reasons I wondered aloud SPX 915 As a Top? – only to discover that while I had indeed found a top, it was in the NDX, not in the S&P 500.

On Thursday, the Philadelphia Semiconductor Index, also known as the SOX, put in a top of its own before reversing hard and declining precipitously. The SOX ended the day down 5.6% and dragged down the NDX and the rest of the technology sector with it. Technology has been in a tailspin ever since the steep drop in the SOX.

The banks were successful in keeping the broader markets in a bullish mode on Friday without the help of the SOX and technology (see The Banks vs. Technology), but starting on Monday, the weakness in technology began to spread to other sectors, even the financials.

The SOX has long been considered a leading indicator, not just for technology firms but also for the market in general. Semiconductors are early cycle technology stocks and an unhealthy semiconductor sector does not bode well for economic recovery.

Going forward, a healthy rally should include the participation of semiconductors, as measured by the SOX and ETFs such as SMH. In an ideal rally, semiconductors should show strong absolute gains and also outperform the SPX on a relative basis. Until we see more strength from semiconductors, I am likely to have a bearish bias.

[source: StockCharts]

Wednesday, May 13, 2009

Advanta and Charge Offs

In a story that I believe was underreported yesterday, the nation’s 11th largest credit card issuer, Advanta (ADVNB), announced it will be suspending all credit card charges on outstanding credit cards as of June 10th in order to “dramatically limit the company’s credit loss exposure and maximize its capital and its liquidity measures.”

As of March 31st, Advanta’s charge-off rate stood at 20%.

The credit card freeze will affect all of Advanta’s almost one million existing small business credit card accounts. While Advanta does not offer personal credit cards, all of the small business accounts are backed by personal guarantees. Given that approximately 25% of the outstanding balances on Advanta’s credit cards are from small businesses in California and Florida, there is a strong possibility that the rising charge-off rate is related to declining real estate values – and that many of Advanta’s small business accounts were sole proprietors using their card ostensibly as consumer credit cards, yet with higher credit lines.

Advanta’s announcement comes less than a week after two other credit card companies, American Express (AXP) and Capital One (COF), passed the government’s stress test and were deemed sufficiently capitalized so as not to be required to raise any additional capital.

Tuesday, May 12, 2009

Another Winner from Jeff Augen

While I never got around to a formal review, I did give Jeff Augen’s The Volatility Edge in Options Trading: New Technical Strategies for Investing in Unstable Markets a Best New Volatility Book award in the VIX and More 2008 Volatility Awards. I thought that book did an excellent job in providing new insights in how to trade the earnings cycle and the options expiration cycle.

I recently had the chance to read Augen’s latest book, Trading Options at Expiration: Strategies and Models for Winning the Endgame and once again had a very favorable reaction. This time around Augen focuses almost entirely on the last two days of the options expiration cycle and offers up some interesting ideas and trading strategies to take advantage of anomalies in time decay and implied volatility.

Augen’s new book does not have the heft of the original, but the focus is one of the book’s strengths.

If you are like me, you probably find the last two days of the options expiration cycle to be among the most difficult periods to trade. After reading Trading Options at Expiration, I guarantee (and how many guarantees are there in the investing world?) that you will look at the end of options expiration week differently and see more opportunities than pitfalls.

With three days until the end of the current options expiration cycle, now is as good a time as any to start evaluating some new strategic approaches.

Monday, May 11, 2009

VIX Term Structure and VIX Forecasts

Last Friday, Jeff Kearns of Bloomberg had a story with the title VIX Futures Show Traders Betting Stock Rally to End that triggered a large number of emails from readers. The quote from the article that seemed to generate the most amount of interest was, “Investors surveyed by Macro Risk Advisors expect the VIX to jump to as much as 51.70 by year end.” In fact, the 51.70 data point was the average high print expected by respondents who were surveyed in April, when the VIX ranged from 33 to 46. That data point and the balance of the results from the Volatility Forecast Survey make for some interesting reading. Even more interesting, however, is the April 2008 Volatility Forecast Survey, in which respondents expected average realized volatility of 20.9% for the balance of 2008, with an average VIX high print of 34.4. One brave soul went out on a limb and predicted that the VIX would spike to a new all-time high of 50.

I guess nobody knew what a category 5 VIX hurricane looked like, so extrapolating from historical data, they were having trouble imagining what was coming.

Getting back to the 2009 survey data, while I find it intriguing, I would put a lot less credence into survey data that is several weeks old than real-time market data. One can construct a VIX term structure graph from VIX futures or SPX options. My preference is for the latter approach, which yields a graph like the one below. Note that the slope of the VIX term structure is almost flat. Certainly the 0.11 differential between the front month and 2 ½ years out is in stark contrast to the 33.93 point differential from November 20, 2008, when the front month VIX was 81.07. Essentially, the consensus opinion is that current volatility measures are about where they should be, with no significant changes anticipated going forward.

Finally, while survey respondents likely had the best of intentions when constructing their volatility forecasts last month, there is nothing like current market data to get a sense of how investors are backing up their beliefs with large dollar value positions in the options market.

[source: CBOE, VIXandMore]

Sunday, May 10, 2009

Chart of the Week: Breaking Out Recent Commodities Moves

This week’s chart of the week looks at commodities, where base metals (blue line) and energy (red line) began to bottom just after the middle of February, about 2 ½ weeks before stocks put in a bottom. Interestingly, agriculture (green line) bottomed on March 2nd, just before stocks found their bottom. Precious metals, which marches to the beat of a very different drummer during periods of economic stress, bottomed back on November 12th and made its most recent high on February 23rd, just as base metals and energy began to rally.

The chart below captures the action in four commodity sub-sector ETFs since February 17th. The chart shows the base metals ETF (DBB) to be the strongest performer during this period. While DBB has faltered in the past few days, energy (DBE) has surged. Agriculture (DBA) has recently joined the bull party and with concerns about rising interest rates heating up, even precious metals (DBP) have started to rally as well.

It would not surprise me if 3-4 of these commodity sub-sector ETFs outperform the S&P 500 index for the rest of 2009. At the very least, they could provide some important portfolio diversification and a potential hedge against inflation.

[source: StockCharts]

Disclosure: Long DBB at time of writing.

Friday, May 8, 2009

How Low Can the VIX Go?

With the bank stress tests results and the April employment report out of the way, volatility is cratering and the VIX is down to 31.45 as I type this.

So how low will the VIX go?

A little more than two weeks ago, in The New VIX Macro Cycle Picture, I suggested that for the current bull leg, 30 was a good guess for a VIX floor. That prediction was part art and part science, to be sure, but there were quite a few technical factors that went into the calculation.

You don’t need a fancy model, however, to make a ballpark prediction for the VIX. I will share a quick and dirty back of the envelope calculation. Since the VIX averages approximately 1.3x the historical volatility of the SPX, one can use the 10, 20 and 100 day historical volatility data to come up with three estimates of the VIX. Generally, I take the lowest one as a floor and average the two readings that are closest together to come up with an expectation of an appropriate current level of the VIX.

With the 10 day historical volatility at 24.10 yesterday, a 1.3x multiplier yields a 31.33 VIX. For the 20 day HV, the numbers are 29.95 and 38.93. The 100 day HV, which includes SPX data going back to December 12th, is 37.52, with a 1.3x multiplier yielding 48.77.

So…the back of the envelope calculations suggest a VIX floor of 31.33 (today’s low is 31.39) and an appropriate current VIX of 35.13.

Remember that these are guidelines at best and assume that the next 30 days will bear a reasonable resemblance to recent history. Still, they support the contention that we are nearing a VIX floor.

For the record, the lowest 10, 20 or 100 day historical volatility level recorded in the past six months was a 10 day HV of 20.38, which translates into a VIX of 26.69. For anyone looking for the lowest possible extreme in the VIX in the near future, 26 would be a good bet. This is also consistent with my earlier prediction that the VIX is not likely to breach a floor of 25-27.

The Banks vs. Technology

I was going to put up a post about the recent negative divergence in technology, particularly the large cap technology companies that dominate the NASDAQ-100 (NDX), but I noticed that Cam Hui at Humble Student of the Markets already beat me to the punch yesterday morning in an excellent Weak Leadership Imperils Market Advance.

Interestingly, since Cam’s post, the divergence between financials and technology has accelerated as the banks have continued to rise in advance of and in response to the release of the stress test results, while large cap technology has been trending down since Monday.

So far the financials (XLF) have done a better job of leading the market up than technology stocks (XLK) have done of inspiring the bears. Until these two sectors start to move in unison, though, I suspect we will have a stalemate.

[source: BigCharts]

Thursday, May 7, 2009

VXX Calculations, VIX Futures and Time Decay

As I type this, the VIX is up about 6.5% for the day and VXX is only up about 2.0%.

While it looks like today is a good day to be long volatility, getting 4/13 of the move in the VIX with a VIX ETN does not look like an efficient way to play the volatility trade. In fact, I have discussed the issue of what I call the VXX juice factor on a number of occasions and have concluded that on average, anyone owning VXX should not expect to capture more than 50% of the move in the VIX, at least based on data since the January 30th launch of VXX. Going forward, however, 40% might be a more realistic target.

A reader asked about the extent to which VXX returns may be adversely impacted by time decay, rolling and other issues.

When it comes to VXX price erosion, there are two primary factors to consider. The first is the mean-reverting tendency of the VIX and VIX futures. The second factor is the daily rebalancing of the two VIX futures that are utilized to calculate the value of VXX.

The VXX calculation is derived from the two nearest months of VIX futures. At the moment, this means the May futures and the June futures. For the sake of simplicity, I will refer to these as the front month and second month futures. I’ll explain the calculation with an example.

VIX options expire on Wednesday, May 20th this month (see 2009 expiration calendar), which means that at the close of business on the day before expiration, May 19th, VXX will hold exclusively the June VIX futures (VX-M9). As each calendar day passes, VXX will sell 1/23 (there are 23 trading days in the current VIX options expiration cycle) of the June VIX futures position and buy an identical amount of the July VIX futures, so that the percentage holdings of the front month and second month futures always create a synthetic blend of a basket of VIX futures with a constant maturity of 30 days. [Note that this is different from the calculations of the cash VIX, where the front month and second month options roll forward one month 8 days before VIX options expiration.]

As long as the near month and second month futures are similar in price, the daily rebalancing has little effect on the price of VXX. When the term structure has a steep slope and there is a substantial difference in price between the front month and the second month (as was the case with SPX options on 11/20/08), the daily rebalancing can generate its own profit and loss. As the graphic below shows, there was a 0.75 difference between the May and June futures settlement prices yesterday. Calculating 1/23 * 0.75, yesterday’s daily rebalancing probably resulted in a 0.03 change in price.

In terms of pricing implications, when VIX futures are in contango (upward sloping over time, second month more expensive than front month), there will be a daily loss of value due to rebalancing. On the other hand, when VIX futures are in backwardation (downward sloping over time), the daily rebalancing process will generate a gain.

Following the launch of VXX on January 30th, VIX futures were consistently in backwardation until the beginning of April, at which point the term structure flattened out. At present, there is some slight contango that could adversely impact VXX prices going forward. Technically, this rebalancing is called "roll yield" and when the roll yield becomes negative, VXX prices will suffer daily losses as a result.

For more on this subject I recommend Standard & Poor’s white paper on VXX returns: Directional Exposure to Volatility Via Listed Futures

For more details on VXX, iPath has two documents worth checking out:

[graphics: FutureSource]

: Long VIX and VXX at time of writing.

Wednesday, May 6, 2009

Sequencing Stocks, Jobs and GDP in a Rebound

Sometimes my ability to overlook the obvious amazes me – and I’m not talking just about my trading.

I should have known I was overlooking something important when several of the recent Abnormal Returns (almost) daily links referenced a blog by the name of Sentiment’s Edge. With Jason Goepfert at SentimenTrader and Brent Leonard at Market Sentiment all over that space, I wondered to myself what need was there for a new entrant in the market sentiment space. As it turns out, Jason Goepfert, who runs the subscription-only SentimenTrader, started a free blog back in January: Sentiment’s Edge. Perhaps it took a sub-35 VIX for me to get my perceptual edge back.

In any event, as a subscriber to SentimenTrader (and I very rarely subscribe to anything), I am delighted to see that Jason is putting more of his thinking out in the public domain. As a rule, VIX and More generally focuses on free content and does not comment on content that is available only via a paid subscription.

If you have never been to Sentiment’s Edge, today is a good day to get a sense of the type of analysis you can expect to find here. In The Economy Vs. the Market, Jason draws upon work from The Pragmatic Capitalist to analyze turning points in stocks, joblessness and GDP. His conclusion? Prior to the dot com crash earlier in the decade, the typical pattern was for stocks to lead, jobless claims to follow and GDP to turn last. Follow the click and the graphics tell the story.

Clearly stocks have made a turn, if not the turn. The trend in initial jobless claims are a little murkier, but if today’s ADP employment numbers are confirmed by tomorrows jobless claims data and perhaps Friday’s employment report, then the old pattern may be returning, with only GDP left to reverse.

Frankly, I probably won’t start to be convinced about an economic turnaround until I see more than a month’s worth of progress on the initial jobless claims data, as well as some evidence that there are improvements in continuing jobless claims as well.

Bullish on VXX

All the preannouncements have taken most of the uncertainty out of the unveiling of the bank stress test results and not surprisingly, volatility has collapsed. With the VIX at 32.53 and VXX last trading at 85.19, this looks like a good time to get long VXX and/or VIX options.

[source: BigCharts]

Disclosure: Long VIX and VXX at time of writing.

SPX 915 as a Top?

I have a strong feeling that the 915 level on the SPX hit in the first half hour of trading today will hold up for awhile. Of course, anything is possible with the bank stress tests and the employment report on deck, but I am betting on 915 holding, especially if the NDX (NASDAQ-100 continues to be relatively weak)

Tuesday, May 5, 2009

Technical Analysis, Condor Options and the Lessons of 2007-09

If you do not have Condor Options on your reading list, then you are missing out on what I consider to be perhaps the most deftly written and intelligently reasoned investment blog out there. To top it off, the topics are timely, there is a liberal sprinkling of wry humor, and if you have a dictionary handy, you can usually increase your vocabulary too.

Don’t take my word for it though. Check out today’s Technical Analysis Fails to Give You a Pony and see for yourself. In what may be my favorite post of the year so far, Condor Options, provides a sharp counterpoint to Michael Tsang and Eric Martin, whose Stock Charts Fail Forecast Test in Complete S&P Miss argues that technical analysis strategies failed investors from the October 2007 peak to the March 2009 decline. The Condor critique includes a discussion of indicator selection and time frame selection. It also notes that each of eight indicators did beat S&P 500 during evaluation period.

Well done, my avian friends.

But before this starts to sound like an infomercial, I want to hop onto a tangential thought that I have been ruminating about for the last few months: what lessons should we take away from the 2007-09 bear market?

Now I know the issue of learning lessons from the recent bear market is a big subject and I have no intention of taking more than a first pass at it this time around, but since I haven’t seen it discussed at any length elsewhere, today seems like a good day to dive in.

First, consider the possibility that there are no lessons to learn from the last year or so. While this may sound heretical at first blush, it is certainly possible that the confluence of events that put the financial system and the markets in peril over the course of the last year will not be repeated during the course of my trading lifetime and perhaps yours as well. This may be a little naïve, but consider that it was 21 years between VIX spikes over 80 and more than 70 years since we have seen a bear market as aggressive as the recent one.

Another way to think about the recent bear market is to consider an analogy to an N-year flood. In preparing for an N-year flood, it may be desirable to build a dam and levee system that is capable of containing an N-year flood. On the other hand, it may make more sense to construct a system that is designed to withstand only a fraction of an N-year flood and to focus more resources on an optimal evacuation plan and communication system.

Switching metaphors, think of the big wave surfer who is comfortable riding 20 and 30 foot winter swells and might consider hopping on a 50 footer at Maverick’s if he or she thought it might win the competition. At some point, however, the waves become too big and dangerous to try to ride. At some point, we are all better off being spectators.

By the same token, it is certainly acceptable to have a trading system that reverts to all cash when certain events hit a global exit trigger. These might includes triggers such as a 20% peak to trough drawdown in the SPX, a close of greater than 50 in the VIX, the loss of 25% or more in one’s account equity, etc.

I do think there are important lessons to learn from the recent bear market, but I think the first thing most investors should consider is that they only need to play the game when the odds are in their favor.

I will have a lot more on this subject in future posts.

Monday, May 4, 2009

SPX Reclaims 900 Level

The S&P 500 index has not traded above the 900 level since the beginning of January, but just edged above that number a moment ago.

In spite of all the recent bullishness in stocks, my evaluation of the risk/reward ratio of the markets has me positioned with a bearish bias at the the moment.

Percentage of NYSE Stocks Above 200 Day SMA

While it is similar in construction to yesterday’s chart of the week (the percentage of NYSE stocks above their 50 day simple moving averages), a chart of the percentage of NYSE stocks above their 200 day moving averages looks much different from the 50 day version and is generally subject to a much different interpretation.

The chart below is a weekly chart of the percentage of stocks trading above their 200 day simple moving averages since 2002. As the graphic demonstrates, the 200 day moving average does an admirable job of capturing the strength of the long-term trend. During the 2003-2007 bull market, for instance, pullbacks to 50 percent represented excellent buying opportunities. Furthermore, when the percentage of NYSE stocks above their 200 day SMA failed to surpass the 60 percent level in October 2007, this should have been taken as a sign that market breadth was weak and the bull market was in danger.

As 200 days encompasses approximately 9 ½ months of trading, large swings in the 200 day percentage data have a tendency to significantly lag the market. For this reason, interpreting the chart below should focus on swings of at least 30 percent that move the aggregate percentages above the 60 level or below the 40 level. Applying this interpretation to the chart below, the current bull move should be considered a bull market when the percentage of NYSE stocks above their 200 day SMA exceeds 60.

[source: StockCharts]

Sunday, May 3, 2009

Chart of the Week: Percentage of NYSE Stocks Above 50 Day SMA

This week’s chart of the week is a little different than some of its predecessors. The chart below is a weekly chart that tracks the percentage of stocks currently trading above their 50 day simple moving averages. The data are available going back to 2002 and show the only other time that the percentage climbed above 90 was in 2003, as the markets were rallying off of the 2002-03 bottoms.

For the most part, the percentage of stocks above their 50 day SMA tends to top out in the 75-85 range and then correct, with corrections that stay above 20-25 representing excellent buying opportunities. On the other hand, corrections that dip below the 20-25 range run a much higher risk of turning into longer-term bear trends.

At a current level of 90.03% above the 50 day SMA, the two month rally has to be considered extended, but not necessarily without any additional headroom. Given the magnitude of the 2007-09 drop, such bullish extremes on a subsequent bounce should not come as a surprise, but they should cause the bulls to be a little more cautious.

[source: StockCharts]

Friday, May 1, 2009

Short-Covering Rally Data Points

On March 9th I put together a portfolio of ten highly liquid stocks and ETFs that had extreme short interest positions. I posted about this portfolio the next morning in Short-Covering Driving Today’s Gains.

I thought this would be a good time to share the performance of these heavily shorted stocks and ETFs during the course of the past 7 ½ weeks. I have the graphics below from to show how the portfolio has performed. As a bond ETF, TLT probably should not be in the group, but since I included it in the original portfolio, I’m leaving it in here for now. For what it’s worth, removing TLT from the portfolio pushes the total return up to 116.60%. Clearly, a large part of the recent gains have come from short covering the likes of Deutsche Bank (DB), MGM Mirage (MGM), and shopping center REITs Macerich (MAC) and CBL & Associates (CBL).


The Looming Commercial Real Estate Crisis

I was going to set aside the subject of commercial real estate for now, but it just so happens that Kevin Hall at McClatchy has penned a superb overview of the potential problems in this area in Next Economic Crisis Looms: Commercial Real Estate Defaults. (Hat tip, Deal Junkie)

Rather than providing some snippets from the McClatchy piece, I recommend that readers click through to read the entire article.

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