FAS Is Now XLF

For someone who gets a kick out of volatility, the arrival of triple ETFs has been a little bit like manna from heaven. Of course the launch of the Direxion triple ETFs back in early November just happened to coincide with the highest VIX readings in history. There is nothing like record volatility, except perhaps record volatility times three.

But a lot has changed since November. The VIX traded in the 80s the month it was launched; today it was as low as 25.02. At the moment the VIX is exactly 1/3 as high as it was when it peaked in November at 81.38. For those who have been selling options, the ride down the volatility slide has been an unusually profitable one. In fact, it is likely that some of the premiums harvested in the last nine months or so will turn out to be the most bloated we will see in our trading lifetimes.

My personal interest in the triple ETFs notwithstanding, these vehicles have received mixed reviews, largely because their suitability as buy and hold investments degrades rapidly after just one trading session – with the problems exacerbated by increases in volatility. On the flip side, the recent decrease in volatility has muted some of the tracking and compounding errors inherent in leveraged ETFs. In fact, in the current environment, the 3x and -3x ETFs are starting to look somewhat tame relative to their history. The two charts below show the (30 day) historical volatility (purple line) and implied volatility (gold line) of the most popular financial sector ETF, XLF, and the 3x financial sector ETF that has taken the trading world by storm, FAS. While there are a number of interesting conclusions to be drawn from these charts, the point I wish to make is that current historical and implied volatility for FAS (top chart) is hovering around the 100 mark, which is about where HV and IV were for XLF (bottom chart) in February, March and April. In other words, the 3x ETF FAS is no more volatile or has more uncertainty in its stock price now than XLF did during the period from October through April. Tracking error aside, FAS is now effectively the ghost of XLF.

[source: iVolatility]

Clean vs. Not-So-Clean Energy

While I have not mentioned it much on the blog, one of my favorite sectors to invest in is the energy sector. When it comes to energy ETFs, the 800 pound gorilla is XLE, the energy select sector SPDR that trades over 20 million shares on a typical day. XLE’s holdings are heavily tilted toward the major integrated oil companies, with Exxon Mobil (XOM) and Chevron (CVX) accounting for slightly more the 1/3 of the ETFs holdings, followed by ConocoPhillips (COP), Schlumberger (SLB), Occidental Petroleum (OXY), etc.

With cap and trade legislation passing the House over the weekend, investing in the energy space is getting even more interesting. XLE is up this morning, as are the popular oil services ETF, OIH (the top five holdings favor drillers and include RIG, SLB, DO, BHI and NE) and the exploration and production ETF, XOP (top five holdings are XEC, PXD, EAC, INT and HK.)

There are a variety of ETFs out there in the clean/green space. Perhaps the best known of these and certainly the most popular is PowerShares WilderHill Clean Energy (PBW), whose largest holdings include a healthy dose of solar companies (top five holdings are FSYS, VLNC, SOLR, ESLR, SOL.) Among the more interesting alternatives is a sibling ETF, PowerShares WilderHill Progressive Energy (PUW), which places more emphasis on energy efficiency and nuclear power and has a list of top holdings which includes MX.TO, ES, PX, USU and CCO.TO. For a solar-only ETF play, Claymore/MAC Global Solar Energy (TAN) is an excellent bet. Note that many of the holdings of TAN are not traded on U.S. exchanges. The current top five holdings are MBTN.SW, FSLR, S92.BE, CTN.DU and SWV.BE. Also in the top ten holdings are two Chinese solar companies whose ADRs are available in the U.S.: STP and TSL.

In the chart below, I have highlighted my favorite all-purpose clean energy ETF, PBW and have included a ratio of PBW to XLE in order to get a sense of the relative performance of clean energy with respect to the broad energy sector. While PBW has pulled back with the broader market during the past three weeks, it has continued to perform strongly against the broad energy sector ETF. As the ratio chart hints at, pairs trades involving clean energy ETFs such as PBW, PUW and TAN vs. XLE, XOP and OIH are one way to play the Washington energy legislation game going forward.

[source: StockCharts]

Disclosure: Long OIH, DO, INT and TSL at time of writing.

Chart of the Week: Might Recent Volume Bottom Doom Stocks?

This week’s chart of the week could easily chronicle the recent decline in volatility, but that’s a story many pundits have already flogged to within an inch of its life, so it’s time for something else. Like volume.

The volume story rarely gets the air (electron?) time it deserves, so I have plucked out a chart in hopes of being provocative.

In the StockCharts lexicon, $NYTV is one of several measures of NYSE volume. Specifically, it is the daily NYSE volume figure reported by the Wall Street Journal and the one I have chosen to standardize on for my own charts. The chart below uses the NYTV numbers to plot NYSE total volume (dotted black line) against the backdrop of a solid gray area chart for the SPX, with data going back to May 2008. To smooth out some of the fluctuations and holiday-induced dips in volume, I have added a 9-day exponential moving average (EMA) as a solid blue line. I have also included a 10-day rate of change (ROC) study below the main chart.

While readers will undoubtedly draw their own conclusions from the chart, I have chosen to highlight three bottoms in the 9-day volume EMA. The first one occurs in late August 2008, just before the Lehman-induced September swoon. The second bottom is from late December, just before the January top. With Friday’s late volume surge triggered by the Russell index reconstitution, the spike in volume is almost certain to confirm that the mid-June volume drought will now become another bottom. The dip in volume coincided with the most recent top in the SPX and it is possible that for the third time in 1 ½ years, the volume bottom could signal a multi-month drop in the SPX.

[source: StockCharts]

VIX Convergence Zone in Mid-20s

Since Fridays are days in which recent VIX lows are often tested, I thought this might be a good time to step back from the typical VIX daily chart and look at a weekly chart. In the chart below, I have elected to go back to the beginning of 2006 to capture the details of what was arguably the lowest volatility year on record so it could be compared with the most volatile year we have witnessed, 2008.

While volatility first began to spike in February 2007, it was not until July 2007 that investors began to come to terms with the potential magnitude of the damage should the subprime mortgage crisis morph into a global financial contagion. From July 2007 to September 2008, volatility was elevated, but seemingly contained in the 16-35 range represented by the blue box in the chart. It just so happens that the midpoint of that range roughly coincides with the 2006 VIX high of 23.81 that is represented by the horizontal green line.

To complete the picture, I have added a dotted green trend line that connects the December 2006 low to the May 2008 low. Like the 2006 high and the median for the blue box, it projects to about the 24-25 range.

This is not to say that the VIX cannot go below 24-25, but given the 3.06% drop in the SPX on Monday and the 2.14% gain yesterday, the current 26.65 level in the VIX does seem inconsistent with recent single day volatility.

[source: StockCharts]

Disclosure: Long VIX at time of writing.

VIX:VXV Ratio Sell/Short Signal

The VIX closed at 26.36 today, down 15.4% from Monday’s close of 31.17 to the lowest closing level since the 25.66 close on September 12, 2008 – the last trading day before the Lehman Brothers bankruptcy was announced.

According to the classic 10 day simple moving average measure, which has the VIX currently sitting 11.7% below that level, the VIX is now in an ‘oversold’ position according to the TradingMarkets 5% Rule as well as a more stringent 10% threshold used by other traders.

From a volatility term structure perspective, the VIX is also oversold. Notably, the VIX:VXV ratio, which compares 30-day volatility of SPX options to 93-day volatility (using the VXV index), closed today at 0.896 today. In the chart below, you can see that when this ratio closes at 0.92 or below, the bears tend to have an upper hand for at least several weeks. When the ratio drops below 0.90, as was the case today, the odds shift even more favorably in the direction of the bears.

In brief, the low current levels in the VIX:VXV ratio suggest that options traders are too bullish and complacent in their 30 day outlook (event volatility) relative to their 93 day outlook (structural volatility.) While these two volatility measures can be brought back into line by lowering estimates of long-term structural volatility, the path of least resistance is for short-term event volatility to rise. This means the odds favor that the VIX will move in the direction of the VXV, which closed at 29.41 today. Of course rising volatility tends to favor the bears at the expense of the bulls. Even with today’s exceptionally strong close, longs should consider taking profits and/or initiating short positions.

[source: StockCharts]

Disclosure: Long VIX at time of writing.

The Next Big Thing?

This morning ProShares launched two new triple ETFs. Now before you exclaim, “Enough already!” consider that the new ETFs are designed to track the daily moves of the S&P 500 index. As such, these are the first 3x and -3x ETFs that track the SPX directly. For this reason alone, the two new ETFs are can’t miss products. While these triple ETFs will have some interesting hedging applications, the fact that they have a target tracking period of one trading day, like the Direxion Daily ETFs, means they will probably become very hot in the day trading space. Don’t be surprised to see 100 million shares traded in both of these within a few months.

The official names of the new ETFs are the Ultra ProShares (UPRO) and Short ProShares (SPXU). For more information on these ETFs, check out their prospectus.

On Twitter

Sooner or later, I feel I needed to share my thoughts about Twitter; since I have added some 1,000 or so followers in the past few days, this seems like a good time as any to speak up.

I have probably been using Twitter on and off for close to two years. From the start, I have had a love-hate relationship with the platform, for a variety of reasons. Initially it was largely a case of poor stability and reliability, then as Twitter made it into the mainstream, it seemed as if it was one too many communications channels – both inbound and outbound. As a result, I have a history of using Twitter in periodic bursts of activity, becoming disillusioned, swearing it off for awhile, then eventually poking my head back in to see if I should give it another test drive. If it sounds like a crazy process, I tried the same approach with classical music for several years and one day suddenly discovered I was in love. (Fortunately, I never took this approach to dating…)

In the last two months I have finally made my peace with Twitter. There is no longer any love or hate, but I think I have finally come to terms with how I would like to use this communications channel. The easy part is outbound communications, where I have decided to differentiate my Twitter posts from the blog by focusing on three areas, in descending order of importance (at least as I see it):

1. ‘Retweeting’ commentary and analysis (largely but not entirely investment-related) that I believe deserves a wider audience
2. Notifying readers of a new post up on VIX and More
3. Offering impromptu comments about intraday market activity

For those who are interested in following me on Twitter, you can find me at Twitter.com/VIXandMore

From my perspective, the more difficult side of Twitter has always been inbound communications, where I prefer not to drink for the proverbial fire hose in real time. I have found that I can keep up with only 2-3 dozen of my favorite Twitter sources – and only for those who tweet no more than a few times per day. So while I get only a small slice of the Twitter community, I get quality input in real time. For the other 300 or so of my regular sources of information, I can always grab their RSS feeds via Google Reader or Bloglines and read the material at my leisure.

I have tried a variety of applications which I thought might significantly improve my Twitter experience, including TweetDeck and others, but none of these has revolutionized my Twitter experience. For my purposes, the best Twitter application I have used so far is Twitterfall, which I first heard about in Traders Atwitter Over New Apps from Theresa Carey’s excellent Investor Brain blog. Part of the reason I have become a Twitterfall fan is that I can use it to set up filters for keywords such as VIX and VXX – so I can scan the entire Twitterverse in real time to see what is being said about these subjects.

Going forward, I hope to continue to use Twitter as an extension of the blog, to highlight some interesting links as I happen upon them and to offer some intraday market commentary that is probably more appropriate for a microblogging platform than for posting in this space.

The 1000th Post

If Blogger’s math is to be believed, this is my millennial post. I had originally intended to roll this post out with limited fanfare, but a strange confluence of events has caused me to reconsider. First, over the weekend, the blog received substantial accolades from Barron’s options columnist Steven Sears in For the Markets, How Tweet It Is. Today, the Wall Street Journal’s MarketBeat columnist Matt Phillips referred to the “VIX-obsessed blog VIX and More” in his Ugly Start of Week for Stocks as Oil Drops, VIX Jumps.

So today I have decided to (briefly) discuss a little bit of the origins and evolution of the blog and to help point the many new readers to some of the highlights from the first 1000 posts.

A Non-Volatile Birth

The story begins in December 2006, with the VIX hovering around 10.00. At the time, I was looking for an online location to serve as a searchable repository for some of my research on the VIX. After sampling some online message boards and determining these were too unwieldy, I decided to try blogging. In the first week of January, I determined Blogger was the easiest way to take the plunge. The VIX handle had already been claimed by another blogger and I figured I didn’t want to box myself into such a narrow subject area anyway, so I settled on the “and More” escape hatch and plunged in with VIX and More: An Introduction. With the VIX barely out of single digits and left for dead by most, I did not expect to see much in the way of traffic, but after a couple of weeks, a few hearty souls started dropping in. To highlight the absurdity of devoting a blog entirely to the VIX, I added the tagline, “Your one-stop VIX-centric view of the universe…” and hoped that the ellipses would be a signal to readers that everything was tongue in cheek.

For some additional context and to underscore the absurdity of the venture, at the time I was trading almost 100% stocks – very few options – and did not include the VIX in my stable of indicators. I did, however, have a strong belief that most of what we learn comes from getting out of our comfort zones, so I embraced this electronic journey as a potential learning opportunity.

Toward the end of February, when some asked what I wanted for my birthday, I joked, “A 20% spike in the VIX, of course.” Well I got a record 64% spike for my birthday and quite a few curious souls who showed up wondering what it all meant. The joke, it turns out, was on me.

By the time Bear Stearns collapsed and the sub-prime meltdown had transformed into a full-blown financial crisis, I discovered that I was probably the only person who had been thinking about and writing about the VIX and volatility almost every day for two years. What started out as a lark has become a serious venture, quoted in such publications as the Wall Street Journal, Financial Times, Barron’s, Globe and Mail, etc.

Blog Highlights to Date…

My hope has always been that this blog can be both serious and fun. It seems like only yesterday that a reader asked for wine pairings with my VIX Weekly Sentiment Indicator and I was glad to oblige. Recently, I decided to tag a select group of posts with the “lighter side” label to demonstrate that the fear indicator can indeed coexist with an occasional attempt at humor.

For some of the most widely read posts, readers can check out the most read posts of 2007 as well as their 2008 counterparts. I will also have the first installment of the top posts of 2009 ready after the first half of the year and I have begun to flag a handful of posts for which I have received the most positive feedback with a hall of fame label.

Finally, those who are relatively new to the VIX and volatility are encouraged to check out posts I have tagged with the educational label or skip directly to the one post everyone should read, Ten Things Everyone Should Know About the VIX.

Innovations

I am particularly pleased by a number of ideas that were born on this blog. These include the VIX:VXV ratio, VIX macro cycles, the Global Volatility Index, fearograms, an options opportunity matrix, “event volatility” vs. “structural volatility”, a conceptual framework for volatility events, the ratio of the VIX to the yield on 3-month T-bills, and even some semi-serious ideas, such as the LEHVIX and the OHFdex (Overripe High Fliers Index).

More Education Than Market Calls

The intent of this blog has always been to stimulate new ideas and make better fishermen out of all of us, as I strongly believe that ultimately we are all self-coached. Occasionally, however, I have not been able to resist making some market calls – and I have had the good fortune to nail several of them. When I make calls, I usually do so to be provocative and because my thinking is clearly contrarian. When to Short China? is one of my most popular posts of all-time, as is Prediction: Direxion Triple ETFs Will Revolutionize Day Trading. In retrospect, these look like no brainers, but at the time, they cut sharply against the grain.

More often than not, I call things early, but close enough. A recent example was calling a bottom on March 5^th – one day early and 21 points too high.

Moving Forward

I am not sure what the future will bring in this space. Some 2 ½ years after diving in I now believe that my analysis of volatility and market sentiment provide me with the bulk of my edge and I find that most of my trades involve options on ETFs, yet I still intend to keep my trading and the blog largely separate. I have a passion for education, market sentiment and options and I think there is a lot of work to be done in terms of elevating the discussion in these areas.

I have also enjoyed seeing the chart of the week become a regular feature and clearly take pleasure in putting together some strange and unusual charts. I expect there will be more wacky charts in the future as well as more synthesis of charts, market sentiment and fundamentals.

The blog has already spawned a subscriber newsletter and a nearly complete manuscript for a book (Trading with the VIX, to be published by Wiley & Sons). I certainly would not have predicted either of these developments and I am keeping an open mind about the future.

Thanks to all who have helped to make this blog possible and have shared their ideas along the way. In the end, it is my firm belief that investing does not have to be a zero-sum game, particularly if the scorecard acknowledges some non-financial benefits.

Chart of the Week: Lack of Volume and Breadth Threatens Bull Move

In the last few weeks, stocks have struggled to add to recent gains, suffering even more from a lack of buying interest than from selling pressure.

The chart of the week below is an attempt to use two basic indicators to capture the lack of volume and market breadth that has undermined the March to mid-June rally. As a measure of market volume, I have chosen to highlight on balance volume (OBV), which is a running total of the volume on up days minus the volume on down days. This indicator is excellent at highlighting trends which are at risk due to declining volume, which is exactly what the warning suggested when there was a peak in OBV during the first two weeks of May.

In a similar vein, the McClellan Summation Index (aka the NYSE Summation Index or NYSI) shows market breadth as derived from the net daily advancing stocks minus declining stocks. The McClellan Summation Index did turn up at the end of February, just before the March bottom and is generally an excellent tool for gauging trends in market breadth.

In addition to the May highs, note that both OBV and the McClellan Summation Index have recently made lower highs as well. While OBV shows some indications of steadying at current levels, the larger concern is the decline in market breadth issues highlighted by the McClellan Summation Index.

Like all indicators, these two are far from perfect, but they often provide important information about the decline in strength and potential for reversal in major trends.

For additional information on the subjects above try:

• The McClellan Summation Index (4/3/07)
• Two Thoughts on the McClellan Summation Index (10/25/07)
• McClellan Summation Index Turns Positive (2/29/09)
• Whither COF? (5/27/08)

[graphic: StockCharts]

VIX at Seasonal Cycle Low

With the VIX now getting comfortable in the 20s, there has been a fair amount of discussion about just how low we can expect the VIX to go in the next few months.

Back in April, in The New VIX Macro Cycle Picture, I predicted that the VIX will likely not drop below the 25-27 area in the current bull market. That prediction has held up so far, but will almost certainly be tested during the summer months.

Most investors tend to think of the summer season as something of a horse latitudes of sorts for trading, with volume tailing off, portfolio managers on vacation and stocks sometimes set to cruise control. As a result, most people equate summer with lower volatility.

While the VIX does tend to follow a distinct seasonal cycle, the truth of the matter is that we are now at the seasonal cycle low, with volatility historically increasing dramatically from June through October. In fact, over the course of the past two decades the increase in volatility has been highest from June to July, increasing by over 10% (1.82 points.) The pattern is quite distinct in the chart below, which shows composite monthly volatility from January 1990 through last month, using 100 as the series mean.

So…while volatility may indeed trend lower as some of the concerns about the global recession are put to rest in the next few months, lower volatility will have to counter the established seasonal cycle.

For some previous posts on the same subject, try:

• The VIX Annual Cycle (12/24/08)
  
  
• A Month By Month Look at the VIX (1/31/07)

[graphic: VIXandMore]

Disclosure: Neutral position in VIX via options at time of writing

Who Trades the VIX and VXX?

Several times in the past, I have had some fun the Trading Patterns feature at optionsXpress, including a February 2008 post, optionsXpress Trading Patterns and the VIX, which examined the securities that optionsXpress customers who traded the VIX were also trading.

Given all that has happened in the past 16 months, I thought it might be interesting to see what the current crop of VIX traders are trading – and also to contrast this with traders of VXX, the VIX ETN.

First, the VIX trader snapshot from February 28, 2008 shows leveraged short positions in real estate, technology and oil.

I have expanded today’s snapshot of the VIX trader to include a larger list of securities. Clearly, some themes remain, such as the bias for leveraged short positions in real estate and finance, as well as interest in some of the most volatile momentum stock plays.

Finally, looking at the VXX trader, both ETFs in general and the leveraged ETF plays in particular are even more important parts of the trading approach.

In terms of conclusions, I am cognizant that the optionsXpress customer base is a retail-oriented subset of the broader trading crowd and not necessarily representative of the bulk of the volume of VIX and VXX trades. From the graphics above, however, it is difficult to make the case that traders are using the VIX and VXX for hedging. Based on available data, traders who trade the VIX and VXX are typically trading the most volatile leveraged securities available. At the very least, the connection between the VIX and leveraged ETFs appears to be very strong among those traders who prefer to focus on the most volatile nuclear-tipped trading vehicles.

[source: optionsXpress]

Disclosure: Long VXX and neutral position in VIX via options at time of writing

VXX:VXZ Ratio

Since its launch on January 30^th, the iPath S&P 500 VIX Short-Term Futures ETN (VXX) has generated an enthusiastic following, with an average volume of 400,000 shares traded each day. The same claim cannot be made of VXX’s more problematic sibling, the iPath S&P 500 VIX Mid-Term Futures ETN (VXZ), where 100,000 share days are more the exception than the rule.

In spite of the lack of popularity, VXZ, which attempts to replicate the changes in VIX futures approximately five months out, should not be overlooked. In fact, comparisons between the movements of VXZ and VXX provide some interesting insights into the ebb and flow of volatility expectations.

Take the VXX:VXZ ratio, for instance. In some respects this indicator is similar to the VIX:VXV ratio I introduced back in 2007. There are some important differences between the two ratios, however, which are worth noting. First and foremost, you can trade both VXX and VXZ; neither VIX nor VXV can be traded directly. Second, and related, both VXX and VXZ are exchange-traded notes (ETNs), while VIX and VXV are indices. Finally, whereas VXX and VXZ look out one month and five months, the VIX and VXV indices look out one month and three months.

For those seeking to compare near-term volatility expectations with volatility expectations several months out, both the VIX:VXV ratio and the VXX:VXZ ratio are excellent tools. From a data perspective, the index ratio has 19 months of real-time historical data. Unfortunately, the VXX:VXZ ratio has only 4 ½ months of real-time (i.e., non-reconstructed) data to draw from. On the other hand, data for the VXV index is sometimes difficult to come by, while VXX and VXZ data are widely distributed.


The chart below shows the full history of the VXX:VXZ ratio, using a 4-day EMA (blue line) as a smoothing factor. While this indicator is still quite youthful, I find it encouraging that the recent bottom in the ratio coincided with a topping pattern in the SPX. Further, the double top in the ratio that completed on March 9^th also coincides with the bottom in the SPX.

Going forward, I will compare the VXX:VXZ ratio to the VIX:VXV ratio and subject both ratios to some additional scrutiny.

[source: StockCharts.com] 

Disclosure: Long VXX and neutral position in VIX via options at time of writing

Selling VIX Puts Pre-Expiration

Selling naked puts on the VIX just prior to expiration can be a surprisingly low risk volatility play.

Normally, selling naked puts is a dangerous strategy because of the risk that negative news can overwhelm the underlying, causing it to gap down and create a large loss. With the VIX, however, spikes are almost always upward, because while threats to equities are relatively easy to identify, it is much more difficult to discern when these threats are suddenly extinguished.

For this reason – and because the VIX has lately shown some reluctance to drop below the recent floor of 27 – selling a naked put on the VIX is a lot less risky than selling naked puts on other securities. Risk to the down side is definitely limited, yet the limitations are not perfectly mathematically quantifiable.

A sale of the June 30 put illustrates one potential naked put sale opportunity. The profit and loss chart below outlines what the trade looks like. With yesterday’s closing price of 30.81, the trade is profitable if the VIX rises, drifts sideways or loses up to 1.61 prior to tomorrow's special opening quotation. The gain is $80 per contract. The profit and loss chart shows that a loss of $170 per contract occurs at 27.50. Assuming 27.00 is a floor in the VIX, then the maximum loss is likely to be capped at $220. While a 12.3% drop in the VIX in one day cannot be ruled out, it is obviously not a very likely scenario.

Reminder: VIX options expire on Wednesdays. The June VIX options expire June 17^th this cycle. The last trading day for these options is today, Tuesday, June 16^rd. (See the 2009 options expiration calendar for more the full 2009 options expiration schedule.)

[source: optionsXpress]

Disclosure: Neutral position in VIX via options at time of writing.

Stock of the Week Winning Streak Ends at 13 Weeks

It was a fun ride while it lasted, but the Stock of the Week (SOTW) winning streak finally came to an end last week, after 13 consecutive weekly winning selections. In the end, it was a scant 0.14 weekly decline in LSB Industries (LXU) that brought an end to the ride, but even with that loss, the SOTW ‘Sequential Portfolio’ is still up 136.9% so far for 2009 and a gravity-defying 368.4% in the 14 ½ months since I introduced that feature as a part of my subscriber newsletter.

For anyone who is interested, I will update the performance of the SOTW in another two weeks and at the end of each quarter on the VIX and More Subscriber Blog.

For more information on the Stock of the Week, try VIX and More Stock of the Week Selection Up 343% in 14 Months.

Open Thread: Do Fibonacci Retracements Work?

Following my recent Dueling Fibonaccis for the SPX, a reader asked if I knew of any 'scientific' studies that attempted to evaluate the usefulness of Fibonacci retracement levels. The short answer is that I am unaware of any detailed studies, nor was I able to dig up anything meaningful with a search of SSRN.

So I turn this topic over to readers:

• Do Fibonacci numbers work as a trading tool?
  
  
• Are you aware of any published analysis which evealuates Fibonacci retracement levels?

Chart of the Week: Four Key Economic Indicators

For the second week in a row, the chart of the week focuses on economic fundamentals. This week I am featuring a graphic from the Federal Reserve Bank of St. Louis, that attempts to summarize current recession in terms of industrial production, real income, employment and retail sales.

Starting from a business cycle peak of December 2007, the graphic below is an effort to normalize and rescale the economic data by assigning an index value of 100 to December 2007 numbers for each of the four statistics, so that comparative changes are easier to evaluate. Note that for each series, the average, high and low values are plotted for each month following the prior business cycle high. For industrial production, employment, and real retail sales, the average series includes the 10 recessions starting with the November 1948 business cycle peak. For real income, the average starts with the April 1960 peak.

In terms of conclusions, the current recession is establishing new lows for industrial production, employment and retail sales. Curiously, real income, while low, is not even approaching record lows.

Note also that in prior recessions, employment and retail sales have usually started to rebound by now, with real income and industrial production taking longer to bottom.

Going forward, it will be interesting to see how long some of these indicators continue to set record lows and how long before they rebound to the levels of the “average recession’”

[As an aside, for those looking for a top notch repository of raw Federal Reserve economic data and some native charting capabilities, the St. Louis Fed’s Federal Reserve Economic Data (FRED) site should probably be your first stop.]

[source: Federal Reserve Bank of St. Louis]

Dueling Fibonaccis for the SPX

I had suspected that I might get some pushback from some of the charting purists about limiting the scope of my Fibonacci retracement lines to a post-Lehman world, particularly since the SPX had already corrected more than 300 points prior to the Lehman Brothers bankruptcy filing.

My explanation, quite simply, is that the investment world changed radically in September 2008, both from a fundamental and technical perspective. I even used the term Market 2.0 to describe the situation at that time. Technically, at that time the markets transitioned from a measured decline to a series of free falls that took ten day historical volatility to as high as 100 in October.

In the chart below, I have superimposed two different sets of Fibonacci retracements on top of almost two years of daily SPX data. The dotted blue lines repeat my post-Lehman world view as presented in SPX and Fibonacci Resistance at 966 earlier today; the solid green lines reflect a more traditional approach to Fibonacci calculations, using the October 2007 high of 1576 as a point of departure. I have highlighted the 50% retracement levels for both sets of calculations, using blue arrows for the post-Lehman data and green arrows for the data going back to 2007. Note that the difference is a full 155 points: 966 in a post-Lehman world and 1121 using the 2007 high.

If the markets continue to rally, I would encourage readers to pay attention to the green Fibonacci lines. In the meantime, I continue to believe that the post-Lehman period – at least while the SPX remains below 1000 – is the appropriate time frame on which to focus our analytical lens.

[source: StockCharts]

SPX and Fibonacci Resistance at 966

At the height of yesterday’s run up to SPX 956, a commenter took me to task for having a bearish bias in the face of a bull stampede. At the time, I was ready to close out most of my short positions, but this decision was conditional on how the market closed. As it turns out, the bearish momentum at the close was enough for me to leave my short positions on.

When it comes to rising markets, there are two things I know for certain:

1. It is very difficult to predict where a strong bull move will run out of steam
   
   
2. Few things in life are more frustrating/expensive than being short when the bulls are pushing stocks to new highs

Combine the two above ideas and the smart play is to wait for a top to be established and at least one lower high to follow before thinking about establishing short positions. There is, however, a case to be made for anticipating some market reversals and the current situation has three important ingredients: resistance; declining momentum; and a large magnitude move that is ripe for reversal.

The chart below highlights some of these issues. I have added Fibonacci retracement lines in blue that utilize the late September post-Lehman highs as their starting point. The key post-Lehman Fibonacci resistance is 966 in the SPX, which represents halfway between the 1265 high and 666 low. In terms of declining momentum, in addition to the obvious recent range-bound trading, the Average Directional Indicator (ADX) shows trend strength (black line in bottom portion of graph) stalling below the 25 level, which signals a weak trend. Further, the positive directional indicator (+DI, green line) is showing an even more rapid loss of positive momentum. Finally, the move from 666 to 956 was a little over 43% and was accomplished in the absence of any meaningful pullback along the way. In other words, this is a large move that is ripe for a retracement.

Of course there are a number of other technical factors that can support the bear case, but this is an outline of the basic premise.

Right now I am short, but it is a relatively small position. Should the bears demonstrate an ability to gain some traction, I will add to that position quickly.

If the SPX closes above 967, I will exit my short positions and return to a more bullish posture.

[source: StockCharts]

Roubini and the VIX

Call me crazy, but lately I have been pondering the sudden disappearance of Nouriel Roubini from the media scene. You could probably add the likes of Meredith Whitney and others to the list of media sensations who rose to fame as a result of successful predictions about the financial crisis and have now been displaced by a different set of pundits who are talking about subjects like green shoots, TARP repayment, and the coming upturn in jobs and housing.

While Roubini’s media star may be setting, the man himself is not slowing down – nor is he backing away from his bearish leaning. Today Roubini is out with Latvia’s Currency Crisis Is a Rerun of Argentina’s and earlier in the week the issue was Green Shoots or Yellow Weeds?

So as I watch the S&P 500 index move above 950, I am thinking about complacency and the possibility of a ‘rebound bubble’ of sorts.

I checked with Google Trends to see what has happened to interest in Roubini and I was not surprised at all to see a chart that resembled that of the VIX. In fact, when I combined the Roubini Google Trends results with the VIX in the graphic below, I was interested to see that interest in Roubini seemed to be a leading indicator of sorts with respect to volatility.

Of course volatility looks as if it may have a stake driven through its heart today, but I am very skeptical that the VIX will be able to drop much below the current 27 level for at least the remainder of the month.

[graphic: VIXandMore]

Disclosure: Long VIX at time of writing.

Historical Volatility Continues to Plummet

Further to this morning's pre-market post, Volatility in Context with VIX at Pose-Lehman Low, today’s 0.35% drop in the SPX means that it has now been four days since the S&P 500 index has moved more than 0.35%.

The range-bound trading is taking a heavy toll on historical volatility (HV), with today’s action pushing the 10 day HV in the SPX down from 21.54 to 18.10 – the lowest reading since September 3, 2008.

The graphic below attempts to put the current historical volatility levels into the context of the past 2 ½ years. Note that the current 10 day HV of 18.10 fits right in the middle of the range for this measure during 2007 (a year of very low volatility) and the pre-Lehman portion of 2008. In fact, given the recent historical record, I would be quite surprised to see 10 day HV fall any farther than the current level for at least another month or two.

Of course the VIX can continue to decline in the absence of falling volatility, but at some point historical volatility begins to provide some semblance of a floor below which the VIX is unlikely to remain.

On the other side of the coin, investors should also be aware that it has now been 26 sessions since the VIX was above the 35 level. If there is a catalyst (such retail sales numbers, housing data, industrial production statistics, Treasury auction results, the FOMC meeting in two weeks, etc.) that will change the volatility equation, then it is reasonable to look to 35 – not 40 or 50 – as the target for a VIX spike.

Finally, with volatility expectations shrinking almost on a daily basis, those who may be interested in speculative buying VIX out-of-the-money calls might find them a lot cheaper than anticipated – and perhaps a lot cheaper than they will be in another week or two.

[graphic: VIXandMore]

Volatility in Context with VIX at Post-Lehman Low

Yesterday the VIX closed at 28.27, its lowest close since the VIX ended the day at the 25.66 level on September 12, 2008 – the Friday before the Lehman Brothers bankruptcy filing.

In addition to the new lows in the VIX, a number of measures of historical volatility (HV) in the S&P 500 index are also at levels not seen since the week of the Lehman Brothers bankruptcy. These include 20 day HV (24.65), 30 day HV (25.50) and 50 day HV (28.57). Further, while the 10 day HV has not yet fallen below recent May and January lows, at 21.54, this is the type of number that makes the 30+ VIX advocates more than a little nervous.

The culprit is recent range-bound trading in which yesterday’s 3.29 point gain in the SPX is actually the largest daily change in the past three trading days. For the last six sessions, the SPX has hardly moved at all, which has driven historical volatility – also known as realized volatility – dramatically lower.

The chart below shows the trends in the VIX and historical volatility in the SPX since last September. Note that since the March lows the VIX has been falling in conjunction with the highlighted 10 day and 50 day historical volatility measures. Note also that the last three times 10 day HV got significantly ahead of the VIX (1/5, 2/5 and 5/6) each time this was a precursor to topping action in the SPX. As the 10 day historical volatility in the SPX gets ahead of the VIX once again, it is reasonable to ask whether this pattern will continue and we will see another topping pattern in the next few days.

[graphic: VIXandMore]

VIX:VXV Ratio Slips Below 0.92 Intraday

Several factors have contributed to my taking a more bearish stance today, including a VIX:VXV ratio of 0.92, up from a low of 0.919 a little earlier.

Among the ways to get long volatility in this environment of rapidly falling volatility is VXX, the short-term VIX ETN, which looks like an attractive long at the current at 74.79.

Stock of the Week Winning Streak Hits 13 Weeks

At the end of May, in VIX and More Stock of the Week Selection Up 343% in 14 Months, I promised to post future Stock of the Week (SOTW) selections here on the blog one day after I flagged them in the subscriber newsletter as long as the string of consecutive winning weeks remained intact. With the 3.5% gain in last week’s selection, Tech Data (TECD), the weekly winning streak is now up to 13 weeks.

This week’s SOTW, geothermal and water source heat pump manufacturer LSB Industries (LXU), lost 0.02 today and dropped the cumulative return since the 3/30/08 inception down to 371%.

Should LXU manage to rally and post a gain for the week, I will carry this feature forward until the SOTW winning streak is broken.

Until then, I am partial to riding the hot hand and seeing where it takes me.

Banks, Large Cap Tech and Leadership

One month ago today in The Banks vs. Technology, I mentioned the divergence between technology and financials and noted, “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.”

Fast forward one month and the divergence has turned upside down. In the chart below, I focus on financials in the form of the KBE banking ETF and large cap technology as exemplified by the NASDAQ-100 or NDX.

As it turns out, May 8^th, the day of the original post, was the top in the banking ETF. Since that date, banks have slowly trended lower (top graphic), even while large cap technology (middle graphic) and the S&P 500 index (gray area chart at bottom) have been making new highs. The change in leadership is perhaps best illustrated by the solid black line in the bottom portion of the chart, which tracks a ratio of KBE to the NDX. In March, April and the early part of May, the ratio quite accurately mirrored the movement in the SPX.

During the course of the past four weeks, however, leadership flipped from banks to large cap technology and the ratio began to decline – all while the SPX continued to make new highs.

I find it particularly interesting that it is not just the relative performance of banks that has declined, but it is also becoming increasingly common for banks and technology to move in different directions on the same day. This has been the case today and has been true for five of the past six days.

I am not surprised to see leadership being passed from financials to large cap technology, but as I said a month ago, I do not expect the market to make any significant additional gains unless the two sectors are able to move up in unison.

[source: StockCharts]

Chart of the Week: Nonfarm Payrolls, Unemployment Rates and Time

As much as I enjoy technical analysis and sentiment charts, it is time the chart of the week addressed one of the many fundamental macroeconomic issues currently being debated.

This week’s chart combines two important jobs numbers from Friday’s employment report: monthly changes in nonfarm payroll employment and the unemployment rate. In some respects, this week’s data seemed to be conflicting, as the nonfarm payrolls were not as bad as expected, yet the unemployment rate was worse than anticipated. Part of the reason for this is that data is derived from two different sources. The nonfarm payrolls are the result of a survey of businesses, while the unemployment rate number is calculated on the basis of a survey of households.

[Without straying too far from the subject at hand, I want to highlight an often overlooked component of the nonfarm payroll that is known as the so-called birth/death model. This statistical construct added 220,000 jobs to the survey results, with the majority of these ‘birth/death’ additions coming from the construction, hospitality and leisure segments. I have some skepticism about the birth/death model adjustments to the May data, but will leave that subject for another post. In the meantime, those who are interested in learning more about what I am referencing may wish to review:

• Current Employment Statistics Net Birth/Death Model
• Current Employment Statistics Net Birth/Death Model Frequently Asked Questions
• Impact of Business Births and Deaths in the Payroll Survey
• Accounting for Business Births and Deaths in Current Employment Statistics
• Technical Information: Estimation Methods for Business Births and Deaths]

The chart below dates back to 1999 and captures the full history of the 2000-2003 economic slowdown and bear market. Note that the peak monthly decline in nonfarm payrolls (dotted black line) was a loss of 325,000 jobs in October 2001. The shaded gray area highlights the subsequent 19 months in which job losses decreased, yet the unemployment rate jumped from 5.3% to 6.3% during this period in what was known as a jobless recovery. As the chart shows, it was a full 3 ½ years before the unemployment rate was able to drop below and remain below the 5.3% level (dotted red line) of October 2001. Worse yet, even the substantial improvement in the May 2009 data puts job losses at a level higher than the 2002-2003 peak. Simply stated, the job situation is not improving, but the rate of deterioration has slowed.

I have no reason to believe that the recovery from current recession will be any faster than the recovery from the last recession. If anything, the arguments for a longer deeper recession seem compelling. Even if we have the same type of jobs recovery that we had the last time around, however, investors may want to think in terms of 3-4 years or perhaps more before unemployment recedes to the 7.6% level from the peak January job losses of 741,000.

[source: Bureau of Labor Statistics]

The SPX and the 200 Day Moving Average

Lately there has been a great deal of talk related to the SPX closing above its 200 day moving average for the first time since the end of 2007.

The first question traders should ask themselves is whether this technical artifact has any relevance to trading. The simple answer is that it depends upon how many people pay attention to the 200 day moving average and incorporate rules related to it in their trading methodologies. For example, there are many traders who prefer – or insist upon – long positions only when the instrument in question is above its 200 day moving average and short positions only when it is below the 200 day moving average. In sum, if enough people pay attention to the 200 day moving average, it becomes a self-fulfilling prophecy of sorts.

But is there an edge in incorporating the 200 day moving average into trading decisions? Condor Options took up this subject earlier today in Exponentially Curb Your Enthusiasm and concluded that since 1965, long only strategies that incorporated the 200 day simple moving average (SMA) and exponential moving average (EMA) for the SPX both beat a simple buy and hold approach. (Interestingly, the EMA approach had a better track record than the SMA approach.)

A quick glance back at a long-term SPX chart show why the 200 day SMA has helped generate excellent timing signals. Note that from 1996-2000 and 2003-2007, the 200 day SMA kept investors in the bull market almost all the time. Investors would have been in cash (or perhaps even short) during the 2000-2003 bear market and from the beginning of 2008 to the present.

Looking at the SPX since the beginning of 2008, one can see the steady decline in the 200 day SMA, which actually peaked in January 2008.

Before getting too excited about the 200 day SMA, it is important to look under the hood at the data that goes into the calculations. Right now, the 200 day window includes data going back to August 19, 2008, when the SPX closed at 1266.69. Tomorrow that number will be dropped from the calculations and replaced with one that is likely to be close to today’s close of 942.46. That is 324 points lost from the index calculations, which means that if the markets drift sideways, the 200 day SMA will be declining at rate of about 1.6 points per day as the higher closes from August scroll off. In fact, since the beginning of 2009, the 200 day SMA has dropped 48, 46, 69, 46 and 37 points in each of the last five months.

Another factor to consider is that the lows of March 6^th and 9^th are now almost three calendar months behind us. That translates into 61 and 62 trading days. It also means that the March lows will be in the midpoint of the data series in 38-39 trading days, which means that the 200 day SMA is most likely to continue to decline until the last week in July before turning back up.

So, go ahead and consider the 200 day SMA to be a potential support level or long/short inflection point, but going forward, this line on the charts should continue to decline and be less and less relevant, unless, of course, the markets follow the green line down.

[graphics: StockCharts]

ETFs, Leverage and Strangles

I was surprised by the volume of the feedback I received from last week’s Using Options to Control Risk in Leveraged ETFs. Clearly there is a great deal of interest in options and leveraged ETFs.

Among the emails I received were several questions about strategies associated with ETFs. For the record, my intent here is not to advocate a particular strategy, but merely to illuminate various strategic building blocks that I believe should be part of the trading arsenal of any options trader.

With that out of the way, let me spend a minute talking about strangles. I realize I have not talked about strangles as much as straddles here, but I actually prefer to trade strangles instead of straddles when I am selling options. Whereas, the point of maximum profit for a straddle is a point that often resembles a Sisyphean lottery, strangles have a maximum profit zone that is much wider and easier to manage.

In the chart immediately below, I have taken a snapshot of a short strangle on IWM, which is an ETF for the Russell 2000 small cap index. The short strangle is created by selling 10 June 50 puts and selling 10 June 55 calls. In this example, the puts have an implied volatility of 37 and the calls have an implied volatility of 31. Note that the maximum profit on this short strangle is $1210 and occurs if IWM closes anywhere from 50 to 55 at expiration. The full profit zone spans 7.92 points from 48.79 to 56.71.

TNA is a 3x ETF for the same Russell 2000 small cap index. Whereas IWM closed at 52.43, TNA closed at 30.66, a little more than 41% below its 1x sibling. Even at a significantly lower price, however, the firepower of the 3x ETF is immediately obvious when you look at the options. The chart below shows the result that is created by selling 10 June 28 puts and selling 10 June 33 calls. As in the IWM example, the strikes have a five point interval. The differences in the profit and loss graphic below are largely a result of the extreme differences in volatility. In this example, the puts have an implied volatility of 92 and the calls have an implied volatility of 87 – almost, but not quite, three times that of IWM. As result of the higher volatility, the maximum profit is $2800 (between 28 and 33), while the full profit zone is 10.60 points, from 25.20 to 35.80.

In brief, for an implied volatility that is about 2.6 times higher, TNA offers a maximum profit that is 2.3 times greater and profit zone that is 1.3 times larger.

These comparisons are admittedly less than perfect, given that the IWM and TNA trade at much different prices, but they certainly convey the essence of the idea that in a range-bound market, an options seller who is short options on 3x leveraged ETFs can rack up large gains (or losses) in a hurry. Of course, this same trade can be made much less risky by "buying the wings" and turning the strangle into an iron condor.

For a related post, check out The Options Opportunity Matrix.

[graphics: optionsXpress]

SPX Daily Returns Since 3/6/09

Lately it seems as if the market has only two directions: up and sideways. Since the March 6^th bottom, that has not been entirely the case, but it hasn’t been too far from the truth.

The graphic below is a histogram that reflects the frequency distribution of daily returns in the S&P 500 index (SPX) since the March bottom. I have shaded in gray the column that represents gains which have fallen in the -1% to +1% range. These are relatively neutral days. The preponderance of green reflects the fact that in the past three months, the relatively few down days have tended to be small drops. On the other hand, positive days have includes more small gains in the 1-2% range, many more larger gains in the 3-4% range, and a couple of exceptionally large gains of 7.08% and 6.37%.

Of course, a chart of weekly returns for the same period would show almost all green and two small patches of red…

Stock of the Week Update (+362%)

Last week, in VIX and More Stock of the Week Selection Up 343% in 14 Months, I promised to post on the blog the current Stock of the Week selection as long as the winning streak (now at 12 weeks and counting) continues.

First, to get caught up with last week’s business, Core-Mark Holding Company (CORE), finished last week up 14.4%. This week’s selection, Tech Data (TECD) posted a 1.4% gain yesterday, bringing the cumulative 14 month return of the Stock of the Week ‘Sequential Portfolio’ to +362.87%.

Eerie Déjà Vu as VIX and SPX Both Jump More Than 2.5%

If you follow me on Twitter (VIXandMore on Twitter), you probably saw my surprise when I asked rhetorically, “When is the last time the VIX was making new intraday highs with the $DJIA up 230?”

While I can’t answer that question (though my guess is that today was a first), I did check to see if today’s close set a record for greatest percentage gains by both the VIX (+3.87%) and the SPX (+2.58%) on the same day.

It turns out there was one previous instance that topped today’s double spike, back on November 27, 2002, which was the day before Thanksgiving. On that day, the VIX was up 4.93% and the SPX gained 2.80%.

I checked the charts to see how November 27^th fit into the 2002-03 bear market lows. As it turns out, November 27^th, which I have indicated with a purple arrow in the chart below, was just two days before an intermediate high which preceded a 17.3% drop that led to the final bottom process some 3 ½ months later. From this point, the markets began to rally and were bullish for more than four years.

The chart below recounts the remarkably similar history from 2002. In that year, the bear market associated with the dot com meltdown bottomed first in July and then again in October, where it hit 768. From that October low, the market rallied to 939 on November 27^th – numbers that are strikingly similar to the November 2008 low and the subsequent January 2009 high.

In 2003, the SPX put in a third and final bottom of 788.90 on March 12^th, before stocks rallied and never looked back.

The question of the day is whether the current market, like November 27, 2002, still has (at least) one more sharp drop in it…or does the current situation bear a closer resemblance to the May 2003 beginning of a new bull market?

For the record, when I relaxed the conditions on the simultaneous VIX and SPX jumps, the day that comes next closest to today and November 27 is May 11, 1990. At that time, stocks were in a bullish uptrend that would continue for another two months, before being interrupted by a 19.8% drop that would last from July to October of that year.

Statistically significant? Of course not. Anecdotally interesting? I think so.

[Finally, if the chart from 2002-03 looks familiar check out Sunday’s Chart of the Week: Emerging Markets. I had to double check to make sure I had not posted the wrong chart.]

[source: StockCharts]

REITs and Retailers Leading Today’s Rally

Below I have captured an excerpt of the excellent StockCharts Market Summary page, which provides a graphical and numerical overview of the day’s action across a wide variety of indices, sectors, geographies and asset classes.

Today I am focusing on the sectors that are leading the rally. These include REITs and retailers, with support from transports, including the air lines. Frankly, there is very little sector weakness across the board, just degrees of strength. While not shown in the graphic below, the yen is also doing well today.

I am somewhat skeptical that today’s rally will have legs, but as long as the breadth of the rally continues, the odds suggest that a reversal is not a high percentage play.

[source: StockCharts]