Frontier ETFs

In yesterday’s chart of the week, I looked at three ETFs with exposure to the Middle East:

• Market Vectors Gulf States ETF (MES)
• Wisdom Tree Middle East Dividend ETF (GULF)
• SPDR S&P Emerging Middle East and Africa ETF (GAF)

It is a little known fact that Middle Eastern ETFs are actually subset of a relatively new class of ETFs called frontier ETFs. Many of these frontier ETFs are single country ETFs, but two in particular stand out as diversified frontier plays:

• PowerShares MENA Frontier Countries Portfolio ETF (PMNA)
• Claymore/BNY Mellon Frontier Markets ETF (FRN)

I list PMNA (holdings) first because it is not a global, but a regional ETF, based on the NASDAQ OMX Middle East North Africa Index. At present the fund has a strong emphasis on the Persian Gulf and should be considered as a slightly more liquid (but still relatively illiquid) alternative to MES and GAF, trading approximately 10,000 shares per day. As of last week, the top country allocations were in the United Arab Emirates (22.6%), Egypt (20.2%) and Kuwait (16.9%).

In contrast to PMNA, FRN (holdings) has taken a much broader and more geographically diversified global approach, without a particular regional emphasis. Specifically, the ETF is designed to track the Bank of New York Mellon New Frontier DR Index. As of September 30, the top country allocations were Chile (28.6%), Poland (15.9%) and Egypt (15.4%).

The chart below shows that the while PMNA and FRN were very similar in terms of performance for the first five months of 2009, the more diversified FRN had been a much stronger performer during the latter half of the year. Not surprisingly, given PMNA's exposure to the Persian Gulf, the gap has widened significantly during the last few days.

In addition to these multi-country frontier ETFs and regional frontier ETFs such as Market Vectors Africa (AFK), it is important to keep in mind that there are many single country ETFs available, with an increasing amount of geographical diversity. Just last week, the first Poland ETF (PLND) was launched. For investors who are interested in single country Middle Eastern ETFs, Van Eck is planning to launch new ETFs for Egypt and Kuwait.

Finally, consider that frontier ETFs are likely to appeal only to investors who can tolerate high levels of risk. The multi-country and single country variants suffer from low liquidity and high volatility, making it unwise to build up large positions until trading volumes increase dramatically from current levels.

[source: StockCharts.com]

Disclosure: none

Chart of the Week: Market Vectors Gulf States ETF (MES)

With all the hoopla over the Dubai debt situation, I am surprised that there has been so little talk about Middle Eastern ETFs in general and ETFs with exposure to the United Arab Emirates (UAE) in particular. Part of the reason for the lack of mention is surely that there is little to choose from; the other problem is a lack of liquidity and investor interest to date. Only two ETFs with strong Middle Eastern exposure warrant mentioning: the Market Vectors Gulf States ETF (MES); and the Wisdom Tree Middle East Dividend ETF (GULF.) Neither of these ETFs is particularly liquid (neither traded over 30,000 shares on Friday) and both have managed to avoid detection by all but the most adventuresome ETF investors.

A third ETF that sometimes gets throw into the mix is the SPDR S&P Emerging Middle East and Africa ETF (GAF.) While GAF trades an average of more than 50,000 shares per day, it is important to understand that this is largely a South African investment at the moment. As of September 30, this ETF had 62% of its assets invested in South Africa, 24% in Israel, 7% in Morocco and 6% in Egypt. Notably absent are positions in the likes of the United Arab Emirates, Kuwait and Qatar.

Between MES and GULF, I have a slight preference for MES as an opportunity to gain exposure to the United Arab Emirates, which is why I have included MES as this week's chart of the week below. At the end of September, MES (holdings) had a 25.5% exposure to the UAE, the second highest country concentration behind a 47.7% investment in Kuwait. By contrast, GULF (holdings) had a 17.5% exposure to the UAE at the same time, which ranked second to Qatar at 30.5%.

In my opinion, there is not sufficient liquidity in either ETF to warrant any sort of trading strategy or large positions at this time, but I would not be surprised to see one or both begin to generate some more impressive volume numbers in the coming week and perhaps open up some new opportunities.

[source: StockCharts.com]

Best Article on Dubai Debt Problem and Related Issues I Have Seen Yet

I think the best way to look at crises (both big and small) is to think of them as learning opportunities. In the last year or so, many investors whose investing universe was narrowly bound by stocks have now become conversant in credit default swaps, the TED spread, the dollar, the carry trade, bank capital ratios and a whole host of concepts and statistics that they didn’t know existed in 2007.

So should the Dubai situation also be a learning trigger. Not familiar with the political structure of the United Arab Emirates? the history of sovereign default? the principles of Islamic banking? Now is an excellent time to learn – and perhaps profit – from becoming better informed about these issues.

I also see the events in Dubai as an opportunity to identify some sharp thinkers who are on top of the situation and whose work I was not previously aware of. One such instance is Bill Mitchell’s Billy Blog, where I encountered Dubai Is Not a Case of Sovereign Debt Default, one of the best articles I have yet read on the Dubai situation. As for the author, how can you not like someone who provides a handy (Political Compass) plot of his ideology, an email address and a cell phone number on his blog? Mitchell describes himself as a professional musician who also just happens to be a Research Professor in Economics and Director of the Centre of Full Employment and Equity at the University of Newcastle, NSW Australia.

One of my mantras is that where there is panic, there is opportunity. Whether you made directional bets on prices or volatility today, I hope at the very least you expanded you knowledge base and sources of information in order to give you a better perspective on events as they unfold next week and going forward.

Dubai Debt Concerns Trigger Spikes in Foreign Volatility Indices

With the S&P 500 and NASDAQ futures both down approximately 3% as I type this on concerns about the ability of Dubai World to repay some $59 billion in debt, tomorrow’s half day session is likely to be ugly and volatile. In a vacuum, this type of event would be concerning, but not likely to cause panic. With the emotional scars of the financial crisis still looming large in the memories of investors (i.e., Availability Bias and Disaster Imprinting), I would not be surprised to see an overreaction in the markets tomorrow.

On average, a 3% drop in the SPX yields a spike of about 12.6% in the VIX. Yesterday the Dow Jones STOXX 50 index of European companies fell 3.36%, yet the VSTOXX, (the corresponding volatility index, which is similar to a pan-European VIX) spiked 28.16%.

For the record, a 28.16% increase in the VIX would put it at 26.25.

With the shortened trading session tomorrow providing below average liquidity and investors having an entire weekend to fret about possible contagion or additional cockroaches suddenly appearing, I am predicting a wild ride.

My general approach to events like this one is to try to fade the VIX spike as it shows signs of having topped, but there are frequently multiple spikes to contend with in these types of scenarios.

I will do the best I can to provide some commentary and analysis as the events of the Dubai World debt problems unfold.

In the interim, readers who are interested in previous posts on related subjects, readers are encouraged to check out:

• A Conceptual Framework for Volatility Events
• Forces Acting on the VIX
• Availability Bias and Disaster Imprinting
• VIX Data to Support Availability Bias and Disaster Imprinting Hypothesis

Recent Blog Links of Note

On a typical trading day, I read or skim posts from about 300 different blogs using the feeds from Google Reader. After being out of the loop for two weeks, I spent a good portion of today getting caught up on what I missed.

Some of the links that gave me a good deal to ponder with respect to the VIX, volatility, options, market sentiment, and ETFs include:

• Do Black Swans Negate Options Premiums? (Surly Trader)
• 2x Inverse ETF Volume Update (Pete, StockMarketAlchemy)
• TradeMonster’s Friendly Options Play (Theresa Carey, Investor Brain)
• A Look at Declining Volume on Five Prior Market Tops (Corey Rosenblum, Afraid to Trade)
• Monday VIXology (Bob Barnes, bzbtrader)
• All VXXed Up (Adam Warner, Daily Options Report)
• Thoughts on Hedging, Volatility (Bernie Schaeffer, Schaeffer’s Investment Research)
• The Distress Index and Stock Returns (CXO Advisory Group)
• Why Is the Boston Marathon More Volatile than the NYC Marathon? (Paul Kedrosky, Infectious Greed)
• Wasting a Good Life Trading (Michael Stokes, MarketSci)

SPX Strangle Pong Post-Mortem

When I first broached the idea of Strangle Pong (a strategy of selling a front month strangle in the SPX one leg at a time), I had every intention of periodically following up to offer comments on the strategy, how it was or was not working, and how a trader might manage a position like the one discussed in order to minimize risk while realizing a large amount of the profit potential.

In Strangle Pong Update, Mark Wolfinger (Options for Rookies) and I discussed the advisability of closing out the short put trade and taking some rather substantial profits. We agreed that keeping the position open in hopes of securing the final 3.65 in profit was not an attractive risk-reward play, particularly since the position had already earned 20.35 in profits. I concluded, however, that “for educational purposes I will opt to keep this an open item on the blog.” When I made that comment, I did not realize that an upcoming trip to Hawaii (the Big Island, where everyone who has an opportunity to do so should ignore the cost and take the helicopter tour of Kilauea) would keep me off the communications grid. What I am left with at this juncture is not the real-time analysis that I had hoped for, but a post-mortem. Usually I would not think a post-mortem would be as instructive, but in this case, I think there are quite a few lessons to learn.

For starters, while it turns out that my original rationale for the trade was rewarded at expiration, the risks along the way did not warrant holding through expiration, at least for me. This is an important point for beginning options traders, who have a tendency to hold their winning and losing options trades through expiration, usually resulting in winning trades giving back some of their earlier profits and all too often losing trades expiring worthless.

To recap, the idea behind the short strangle was to capitalize on the possibility of range-bound trading in the SPX in the 1040-1100 area during the last 16 days of the expiration cycle. The objective was to leg into the trade based on which end of the range the SPX was trading. The first leg was a short November SPX 1040 put that immediately went in the wrong direction. As the table below shows, the SPX broke 1040 and closed at 1036 and change (red shading) on the day the trade was initiated. With a maximum gain of 24 points, the trade was already a 5.45 point loss at the end of the first day. More importantly, a critical part of the trade thesis – that 1040 would provide support – was no longer valid. The bottom line is that there was very good reason to cut losses on day one and close out the trade.

As it turns out, my market timing signals earned their keep the next day as buyers jumped in, with support coming in the 1029-1030 area and the SPX beginning an almost uninterrupted bullish run for the next 13 trading days. After 5-6 days, the SPX had recovered to the middle of the target 1040-1100 trading range (blue shading) and two thirds of the potential profit had already been realized.

The week prior to expiration saw the SPX take a run at 1100 and just fall short. During that week, the 1040 puts fell all the way down to 1.40, while the November 1100 calls moved up in price on Monday and Wednesday (bold blue type). The short 1100 call position that Mark and I discarded as too risky on Monday at 8.40 would have been a loser from Monday through Thursday. While the short 1100 call eventually became profitable on Friday, the following week the SPX broke out over 1100 and closed near 1110 on Monday, Tuesday and Wednesday, with the calls still unprofitable and threatening to incur larger losses.

Getting back to the original rationale for the trade, once the SPX closed above 1100 on Monday, upside resistance was broken and the risk was too high for a relatively small reward. At that stage – and with only four days remaining prior to expiration, I would have closed the trade at a loss of 3.20.

So to recap, while this looks like a perfect short strangle on paper, with both the short put and the short call expiring worthless, prudent risk management would not have resulted in holding the trade until expiration. Further, not only would the profits on the short put have been taken early (netting 20.35 out of a possible 24.00), but if the short call leg had been initiated (and I thought this was a questionable trade at the time of the Strangle Pong Update), I would certainly have cut my losses (-3.20) before giving the trade a chance to make a profit.

The bottom line is that this was a great trade on paper, but with proper risk management, is was merely a very good trade in terms of profits, netting only about 60% of what would have been earned if the strangle had been held to expiration. Over the long run, however, I maintain that understanding the risk-reward profiles of existing options positions is more important than trying to extract the maximum profit from each options trade.

For the two previous posts in this series, readers are encouraged to check out:

• Strangle Pong
• Strangle Pong Update

Chart of the Week: No More Free Lunch for Volatility Sellers?

One month ago the VIX closed at a 2009 record low of 20.69, so it should not be a big surprise that realized volatility over the course of the past month has been higher than predicted by the VIX. What I find interesting about this development is that last week was the first time since February 27^th (exactly one week before the market bottomed) that 21 day realized volatility turned out to be higher than the level of volatility predicted by the VIX.

What does this mean?

In the chart of the week below, I show the relationship between the VIX and realized volatility 21 days hence since the beginning of the year. The key point to emphasize is that since the beginning of 2009 (actually going back to 11/20/2008) the VIX had anticipated higher volatility that actually occurred in the next 21 trading days in all but 9 trading days in February – until last week. On Monday, Wednesday and Friday of last week, the nine month string was broken, as 21day realized volatility exceed that of the VIX from 30 days ago.

While one may argue about the ability of the VIX and realized volatility to predict market direction (in my opinion, it is a reasonably successful indicator, but a long way from perfect), there is no arguing that those who have been selling volatility and pocketing easy money since the March bottom in stocks are now finding that the ‘volatility gap’ which had been providing such reliable profits is no longer intact.

Going forward, I think the gap between the VIX and realized volatility should be watched for market direction clues, but more importantly, it should provide clues about whether opportunities to sell volatility for an easy profit are still available – and thus provide a window into the mind of options traders.

For additional posts on related subjects, readers are encouraged to check out:

• The Gap Between the VIX and Realized Volatility
• VIX Data to Support Availability Bias and Disaster Imprinting Hypothesis
• The VIX:VXV Ratio, Availability Bias and Disaster Imprinting

Chart of the Week: Four Key Sectors Struggle

While I still have at least one and a half feet placed firmly in the bull camp, I am increasingly concerned with a number of signs from some key technical indicators. Near the top of my list of concerns is market breadth, as measured by the McClellan Summation Index and other similar market breadth indicators. The bottom line is that if the indices continue to advance on the strength of a narrow base of rising stocks while the majority of issues move sideways or decline, then the rally will have trouble sustaining itself.

During the last few weeks, several key sectors have been underperforming the S&P 500 index, notably banks (KBE); homebuilders (XHB); retailers (XRT); and semiconductors (SMH). This week’s chart of the week shows the performance of the four sectors relative to the S&P 500 index over the course of the last six months. In all four instances, these critical sectors are below the 50 day average of their ratio to the SPX and in the case of the banks, the relative performance gap is increasing almost on a daily basis.

Going forward, I would expect that the major market indices such as the SPX will have difficulty making new highs if all four of these sectors continue to underperform on a relative basis. For this reason, I will keep an eye generally on market breadth and specifically on these four key sectors.

For additional posts on related subjects, readers are encouraged to check out:

• Chart of the Week: Lack of Volume and Breadth Threatens Bull Move
• Three Pivotal Sectors: Financials; Homebuilders; and Consumer Discretionary
• Two Thoughts on the McClellan Summation Index
• The McClellan Summation Index

[source: StockCharts]

Peak Oil, IEA Whistleblower Update, etc.

I have been traveling and have had limited connectivity for the past few days, but I note that the Peak Oil post has generated a fair amount of interest and that others are running with the story, notably:

• Chris Martenson in "The Implications and Fallout in the IEA 'Leaks'"
  
  
• Eric Stewart of The Daily Loaf in "IEA Whistle Blower Reports that Oil Supplies Are Lower than We're Being Told"

VIX Data to Support Availability Bias and Disaster Imprinting Hypothesis

At the risk of beating to death last week’s theme of availability bias and disaster imprinting as part of the explanation for some of the “realized volatility gap, persistent VIX futures contango and off-center VIX:VXV ratio,” I thought it might be informative to present a simple piece of research which supports the idea that the 2009 volatility picture has been an extremely abnormal one.

In the 20 years of VIX historical data, the VIX has typically overestimated the realized volatility 21 trading days hence, which is reflected in the chart below by the dotted green RV (+21d) line. In fact, the gray area portion of the graphic, which represents the difference between the VIX and realized volatility 21 trading days later, was close to 30% in the first half of the 1990s; more recently it has been averaging closer to 20%. The VIX actually fell below realized volatility for 2008, which is not surprising, given the volatility extremes of October and November. What is particularly noteworthy about this chart, however, is that during 2009 the VIX is actually 3.8% higher than it was in 2008, which realized volatility has actually fallen 24.7%. It is almost as if the VIX refuses to believe that realized volatility is declining and insists that the gravitational forces of mean reversion be suspended until further notice. This is a large part of the reason why 2009 has been a boon to options sellers.

For additional posts in this series, which I have listed in reverse chronological order, readers are encouraged to check out:

• The VIX:VXV Ratio, Availability Bias and Disaster Imprinting
• Availability Bias and Disaster Imprinting
• The VIX Spike Conundrum
• Anchoring and VIX of 20
• The Gap Between the VIX and Realized Volatility

IEA Whistleblower Says Oil Production Capacity Deliberately Overstated

I am neither an alarmist nor a conspiracy theorist, but I have been extremely concerned about Peak Oil long before I took on the VIX a pet project. Now that I occasionally find myself as an unofficial source of all things VIX and volatility, it seems I am also perpetually on the lookout for storm clouds on the horizon.

Where will the next big threat come from? commercial real estate? failed Treasury auctions? the dollar? Pakistan?

According to The Guardian, a sure bet is Peak Oil. In Key Oil Figures Were Distorted by U.S. Pressure, Says Whistleblower, Terry Macalister reports that the International Energy Agency (IEA) has been deliberately publishing overly optimistic oil production capacity data, largely due to arm twisting by the U.S. government. Macalister quotes two different unnamed IEA sources, including one who assesses the situation as follows:

“The IEA in 2005 was predicting oil supplies could rise as high as 120m barrels a day by 2030 although it was forced to reduce this gradually to 116m and then 105m last year. The 120m figure always was nonsense but even today's number is much higher than can be justified and the IEA knows this. Many inside the organization believe that maintaining oil supplies at even 90m to 95m barrels a day would be impossible but there are fears that panic could spread on the financial markets if the figures were brought down further. And the Americans fear the end of oil supremacy because it would threaten their power over access to oil resources.”

A second IEA source attributes much of the unrealistic data to a culture in which it was “imperative not to anger the Americans.” Speaking about the current state of oil production, he added, “We have [already] entered the 'peak oil' zone. I think that the situation is really bad.”

Now I take everything I read with a grain of salt, but I think the important question here is whether the quotes from above are the complete truth or merely mostly truthful. If I were looking to predict future disaster scenarios, Peak Oil would be near the top of my list. The question here is not if, but when – and what sort of ugly political and economic consequences will be intertwined with Peak Oil.

The financial crisis may have temporarily postponed the Peak Oil train wreck, but a slow-motion train wreck is hardly an improvement – and often turns out to be more painful to watch.

For some related posts, readers are encouraged to check out:

• Waiting for the Next Show to Drop?
• The Shape of Capitulation in the VIX?

Strangle Pong Update

On October 30^th, in Strangle Pong, I talked about the possibility of legging into an S&P 500 index strangle, starting with the sale of a November SPX 1040 put and looking to sell a November SPX 1100 call when the index rallied back over 1080.

Here we are six trading days later and the SPX November 1040 put, which was at about 24.00 at the time of my original post has fallen back to under 4.00 as I type this.

The table to the right shows the closing values for the 1040 put (SPQWH) and 1100 call (SPTKT) since I originally mentioned the strangle (the values for today are the midpoints between the bid and ask as of 1:00 p.m. ET.) The table shows that the both the bounce in the SPX (from 1043 to 1086) and the substantial drop in the VIX (from about 28 to 23) have significantly eroded the value of the 1040 put. Interestingly, the increase in value in the 1100 call is nowhere near as dramatic as the movement of the puts, as time decay has neutralized some of the gains that were realized by an increase in the underlying.

Frankly, this would be an excellent time to close out the short put position and pocket a nice profit. Sticking to the original line of thinking, however, a trader could let the short put run and short the 1100 calls to open up the other leg of the strangle. The risk-reward is not as attractive as it was for the short put, but assuming (and this is perhaps the most important assumption here) that 1100 continues to serve as upside resistance, pocketing 8.40 for the call is an attractive opportunity.

Note that this strangle is not hedged in any way. As noted previously, once can limit risk in a strangle by “buying the wings” (offsetting long put positions below SPX 1040 and offsetting long call positions above 1100) and converting this position into an iron condor.

For related posts, readers are encouraged to check out:

• Strangle Pong
• VIX Defining a Range Between 22 and 30
• Round Number Magnet Strangle

Chart of the Week: Unemployment Rates and Education

While I have a bias in favor of using home grown charts for my chart of the week, this week one chart in particular stuck in my head, the chart below from EconomPic Data that compares recent changes in the relative level of unemployment to the overall unemployment rate.

It may take a moment for readers to get their bearings on this graph, but in essence it shows that one’s level of education has increasingly become a factor in the likelihood of being unemployed. A decade or so ago, the unemployment rate for someone with less than a high school degree (dark blue line) was about 2% higher than the average for the population, while the unemployment rate for those with a bachelor’s degree or higher was about 2% lower than the average for all workers. By 2009, the gap had tripled to the point that less than a high school degree translated into a 6% higher unemployment rate and at the same time a bachelor’s degree or higher now meant about a 6% lower unemployment rate.

Not surprisingly, data shows that educational levels are highly correlated to income levels and rates of unemployment. While these facts should not come as a surprise to anyone, they certainly explain some of the recent income inequality data and should also have interesting political, social and other repercussions going forward.

[source: EconomPic Data, Bureau of Labor Statistics]

Combining Bollinger Bands and Rates of Change in the VIX

As far as I can tell, I have not yet posted about the use of Bollinger bands in conjunction a rate of change (ROC) indicator to identify volatility breakouts.

In summarizing the action in the VIX over the course of the past two weeks, the chart below captures some of the drama in terms of 10% (solid green) and 20% (solid blue) moving average envelopes. In the six month time frame included in the chart, the moving average envelopes flag last week’s VIX spike as the most powerful since stocks turned up in March. The moving averages also indicate that the VIX low of 20.10 from three weeks ago is the second strongest in terms of penetration of the lower moving average envelopes.

The study below the main chart utilizes a 10-day rate of change function as well as Bollinger bands that are tuned to 20 days and 1.6 standard deviations. Note that in this study both the VIX spike and the prior VIX low represent the largest upward and downward moves in terms of magnitude relative to the Bollinger bands.

The rate of change indicator is a valuable way to measure sharp price moves. When combined with the Bollinger band indicator, it is possible to better identify sharp upward and downward moves, particularly when the underlying has a habit of making sudden large moves, as is the case with the VIX.

For additional posts on related subjects, readers are encouraged to check out:

• VIX Spikes Above Bollinger Bands
• The VIX and Bollinger Bands
• Bollinger Bands and the Standard Deviation Setting
• Charting the VIX with 10 Day SMA Envelopes
• Chart of the Week: Might Recent Volume Bottom Doom Stocks?

[source: StockCharts]

Open Thread: How Has Your Trading Changed?

My recent foray into issues of investor psychology and behavioral finance assumes that traders have learned a number of lessons and/or changed the way they trade as the result of the events of the last year or two.

So...in what ways has your trading changed? What lessons have you learned? How are you different as an investor now than you were before the Lehman Brothers fiasco?

The VIX:VXV Ratio, Availability Bias and Disaster Imprinting

Once a popular subject in this space, the VIX:VXV ratio appeared to be a casualty of the financial turmoil and record volatility spikes in October 2008, when the ratio spiked to record levels an generated a buy signal that turned out to be nothing short of a disaster.

I was not yet ready to give up on the VIX:VXV ratio, so I was pleased to see that from November to January it generated some helpful long and short signals. In a promising development, on March 2^nd the ratio generated a buy signal just before the markets bottomed. When the VIX:VXV ratio urged caution in June, I had even more reason to be hopeful. Then, once again, the ratio had another big miss, issuing a sell signal in mid-July just after the markets started rallying. To compound matters, instead of moving back toward the neutral zone (between 0.92 and 1.08), the ratio persisted with a bearish recommendation all the way to the October top.

I was just about to consign the VIX:VXV ratio to the “Sometimes Useful But Not Always Consistent” bin, but decided to reconsider when I started thinking about volatility levels in the context of availability bias and disaster imprinting, as well as The Gap Between the VIX and Realized Volatility and VIX Spike and VIX Futures Contango Means… As I see it, all these subjects are related. The realized volatility gap, persistent VIX futures contango and off-center VIX:VXV ratio (see chart below) are all symptoms of a market that is not functioning as it normally does, while availability bias and disaster imprinting are the main causes of this situation.

Further, the fact that the VIX futures term structure is now flat and the VIX:VXV ratio hit a new post-March 6^th high of 1.056 last Friday suggests that the volatility picture may be starting to assume some of its pre-Lehman characteristics – if not exactly returning to a ‘normal’ state of affairs.

Personally, I still think the VIX is a little higher now than realized volatility will be a month from now, but a high VIX relative to realized volatility may turn out to be one of the more persistent effects of the global financial crisis, as each investor has their own personal half-life for how long availability bias and disaster imprinting will cast a shadow on their view of the investment landscape.

For additional posts on some of the above subjects, readers are encouraged to check out:

• Availability Bias and Disaster Imprinting
• The VIX Spike Conundrum
• Anchoring and VIX of 20
• The Gap Between the VIX and Realized Volatility

[source: StockCharts]

Disclosure: Short VIX at time of writing.

Availability Bias and Disaster Imprinting

After I dashed off The VIX Spike Conundrum, it occurred to me that there might be some aspects of behavioral finance that have contributed to what is now a full year of continued overestimating of future volatility. I detailed this phenomenon in The Gap Between the VIX and Realized Volatility and is also being reflected in up in a VIX:VXV ratio that has been stuck at unusually low levels from mid-July until last week.

In thinking about the various elements of behavioral finance that impair ‘rational’ decision-making and could contribute to excess implied volatility, one factor that immediately comes to mind is availability bias (nicely summarized in Wikipedia.) The global financial crisis and VIX spikes into the 80s were so vivid and memorable – and so thoroughly discussed in the media – that they are all too easy to recall one year later, even though arguably most of the risks associated with a VIX of 80 have since passed.

I do not think that availability bias is the only explanation for recent excess implied volatility. My working hypothesis – which I do not believe has been addressed by the behavioral finance crowd – is that another factor is as work. I call it “disaster imprinting” for lack of a better name. Disaster imprinting refers to a phenomenon in which the threats of financial and psychological disaster were so severe that they continue to leave a permanent or semi-permanent scar in one’s psyche. Another way to describe disaster imprinting might be to liken it to a low level financial post-traumatic stress disorder.

I will do some additional research to test the disaster imprinting theory, but for now I wanted to throw the idea out and see what others think. Has going to the brink of a global financial meltdown impaired our collective ability to assess future probabilities? If so, how long will this impairment last? As always, all comments are appreciated.

For additional posts on related subjects, readers are encouraged to check out:

• The VIX Spike Conundrum
• Anchoring and a VIX of 20
• The Gap Between the VIX and Realized Volatility

Disclosure: Short VIX at time of writing.

The VIX Spike Conundrum

I have been absolutely astonished by the number of comments I have seen in the past few days to the effect that right now is an excellent time to initiate new long positions on VIX options. I am still not sure what is behind most of this thinking, but it seems as if quite a few investors are excited about the VIX breakout, some have adopted a Roubiniesque pervasive pessimism and others clearly are still operating under the shadow of the 2008 volatility spikes.

For all those who think that a VIX spike of 50% is a good time to get long the VIX, my response is that your ship has already sailed.

I gave this post the title of The VIX Spike Conundrum because like a hot Chinese solar stock, a rising VIX seems to be attracting the momentum crowd. Betting that a 50% rise in the VIX is just the beginning of a larger move is a sucker’s bet. In the event that readers find the data in the two studies linked at the bottom of this post not to be sufficiently compelling, I have added a new study that looks at what happens to the VIX following the first time it spikes high enough to close above 30. Not surprisingly, it is yet another example of mean reversion at work.

The graphic below is a histogram that summarizes the future VIX action after an initial close above 30. Of the 51 instances the VIX closed above 30 without having closed above 30 in the previous session, 18 times the VIX closed below 30 on the next day and an additional 12 instances reflect the VIX closing below 30 two days hence. This means that 59% of the time the VIX has surrendered the full distance of the close above 30 as well as some additional territory in just two days. Looking out four days, the VIX has already closed below 30 some 75% of the time, as is shown by the dotted red line.

Note that while 84.3% of the time the VIX has already closed below 30 just six days later, the remaining 15.7% of the instances can make or break a trader. Six times (11.8%) the VIX has remained above the 30 level for at least 23 consecutive days following the first close above 30. This is slightly more than one full options cycle. Prior to October 2008, traders who were short VIX calls could reasonably expect that the VIX was not going to spike any higher than 45, which was the all-time record in the VIX at that time. Now that we have had front row seats to witness the VIX spike above 80 on two separate occasions, I suspect investors overestimate the likelihood of a VIX spike of this magnitude happening again. Short of another acute systemic threat, I would be quite surprised to see the VIX rising over the 45 level.

In the current market environment, the odds favor short volatility positions, such as bear call spreads on the VIX. Long positions in VIX calls are not just low probability plays, but they are very expensive as well. I don’t mind, however, if speculators are eager to gobble these up, as I am glad to have a ready audience to buy some VIX calls.

For related posts on this subject, readers are encouraged to check out:

• VIX Spike of 35% in Four Days Is Short-Term Buy Signal
• Long the SPX on New VIX Record Closes

Disclosure: Short VIX at time of writing.

Chart of the Week: Reverse Engineering a Critical Moving Average

This week’s chart of the week is a simple reminder that while many of us like to standardize on 20, 50 and 200 day moving averages, these rarely always align perfectly with historical data. In fact, it often makes sense to develop customized moving averages that circumscribe past price action in order to get a better understanding of how current forces acting on stock prices compare to past forces.

One such example is in the chart below. The ‘usual suspects’ of moving averages fail to identify support levels from the July SPX low of 869. When this happens, then a little trial and error can quickly produce exactly which moving average provided support to the underlying. In this case an 85 day moving average did the trick. While I am not saying that an 85 day moving average is the answer to all charting problems, it is reasonable to expect that if the current market downturn penetrates the 85 day moving average, it will be a move that is comparable to or more powerful than the July pullback.

Sometimes data optimization can be a dangerous game, but when it comes to moving averages and charts, optimizing can serve a useful purpose.

[source: StockCharts]