Tuesday, August 30, 2011

Economic Data Not Supporting Gloom and Doom Forecasts – At Least for Now

For over a year I have been examining how economic data in the United States has been faring relative to expectations and have been posting graphics that show the trends in five groups (manufacturing/general, housing/construction, employment, consumer and prices/inflation) in order to get a better sense of which pockets in the economy have been exceeding expectations and which have been lagging. [For the detailed graphics see links 2-8 below.]

The last time around (Economic Data vs. Expectations and Stock Prices, June 2, 2011) I elected to switch to a graphic which aggregated the data across all five categories in order to drive home the main point, which was that the economic reports were consistently missing expectations, sometimes by a wide margin, even though stock prices seemed to be largely treading water. Stocks held on for another few weeks, but ultimately they began to act like the data – as if they had an anchor tied to their ankle.

Today’s consumer confidence data was another big miss, but the trend for the last two weeks has been one of data that is slightly better than expected. At the very least there are some signs that the deluge of bearish data which began in early May ran its course during the third week in August. Whether this is just a pause before the August swoon begins to show its impact in next month’s data remains to be seen, but for now at least the data show slowing growth. Call it partly cloudy and a chance of gloom.

Finally, I cannot help but wonder aloud once again about the old dictum that the stock market looks not at the current economic environment, but at what conditions are expected to be in about 6-9 months. In the chart below it appears that for the better part of the past year, stocks have been more of a simultaneous reflection of current data than a predictor of what may lie down the road.

Readers who are interested in more information on the details of the economic data included in this graphic and the methodology used are encouraged to check out the links below. For those seeking more details on the specific economic data releases which are part of my aggregate data calculations, check out Chart of the Week: The Year in Economic Data (2010).

Related posts:

Disclosure(s): none

[sources: various]

Thursday, August 18, 2011

Echo Volatility and Another VIX Double Top

Back in 2007, I wrote extensively about the phenomenon I dubbed echo volatility, in which large VIX spikes are frequently accompanied by a second spike of similar size in the month or so following the initial spike. Following the twin VIX spikes over 80 in 2008, I reprised this them in a post I titled The Significance of Double Tops in the VIX.

Lo and behold, here we are in another volatility storm and we have what looks like it was a VIX top of 48.00 on August 8th followed by a spike to 45.28 today – a nine day span between VIX spikes.
Of prior instances of VIX double tops, certainly the most dramatic comes from 2008, when the VIX hit an all-time high of 89.53, pulled back more than 45 points, then spiked all the way back up to 81.48 some 20 trading days later. The timing of these VIX spikes was eerily reminiscent of the 1998 Long-Term Capital Management fiasco, when the VIX hit 48.06 on September 11th, then exactly 20 days later hit a crisis high of 49.53.

In addition to those 20-day periods between VIX spikes, there is also precedent for a 9-day twin top going back to 2002, coinciding with the WorldCom bankruptcy filing. Here we saw a top of 48.46 on July 24th and a secondary spike to 45.21 nine days later.

In sum, of the top seven highest VIX spikes recorded to date, four of these have seen two separate spikes in which the VIX exceeded 45, with those spikes falling from 9 to 20 days apart.

Clearly there are fundamental factors that can trigger another VIX spike above the 45 level before the current volatility storm has passed, but if history is any guide, two is likely to be the lucky number.

Related posts:

[graphic: StockCharts.com]
Disclosure(s): short VIX at time of writing

Friday, August 12, 2011

The Convergence of VIX and VIX Futures at Expiration

VIX futures and options expire 30 days prior to the expiration of options in the S&P 500 index for the following month. With the September SPX options expiration set for September 16th, this means that August VIX options will expire on next Wednesday, August 17th.

Students of the VIX (and there seem to be many when the VIX spikes over 40) should all know that over the course of their life, VIX options are not priced off of the VIX index. Instead, the best approximations for the appropriate underlying for VIX options are the corresponding VIX futures. The one caveat is that at expiration, the VIX index and VIX futures must converge on a single price for the VIX. This price convergence in the VIX and VIX front month futures is always interesting to watch, but particularly so in high volatility environments.

The mechanics of the VIX settlement process are non-trivial, but suffice it to say that they settle with a Special Opening Quotation (SOQ) at Wednesday’s open, based upon opening trades (as well as the midpoint between the bid and ask) in SPX options. As a result, the last opportunity to trade VIX August futures and options is the session before the SOQ, at Tuesday’s close.

With two full trading days plus 1 ½ hours of today’s session left, there is a substantial discrepancy between the VIX and the VIX futures. As I type this, the VIX is at 36.40 and the August VIX futures are at 34.50. Somehow that gap needs to be closed in the next two days. Right now the market’s best guess is that the VIX will fall 1.90 points by Wednesday’s SOQ, but of course the final settlement could be between the two current values and quite possible above 36.40 or below 34.50. If you are trading any of these instruments, you should be aware of the price gap and the path of the convergence. You might also use this opportunity to brush up on the little-known near-term month VIX index (VIN) by checking out VIN, VIF and an Obsolete VIX.

Related posts:

Disclosure(s): Short VIX at time of writing

Thursday, August 11, 2011

VIX Suggests Investors Don’t Believe Rally Is Sustainable

Back in 2007 and 2008 I had a shipload of posts talking about the SPX:VIX correlation, its implications for stocks and the like. I even came up with a plot that I called a “fearogram” to map how changes in the VIX relative to the SPX compared with historical norms and recently dove into the subject of VIX convexity and the movements of the VIX relative to the SPX in a June 2011 Expiring Monthly article, VIX Convexity.

I mention all this because in the recent downturn the VIX has moved much faster to the upside than the SPX has to the downside, given the historical rule of thumb that for every 1% change in the SPX the VIX moves approximately 4% in the opposite direction. For instance, from August 3 to August 8 the SPX lost 11% over the course of three trading days. During the same period the VIX more than doubled, gaining 105%, considerably more than the 44% or so one would have expected. One could argue that much of the move in the VIX over and above the anticipated 44% gain represented fear and irrationality flooding into the markets.

As I write this the S&P 500 index is up 5.2%. At the same time, the VIX is down about 11.8%, close to half of the anticipated -4x move.

So to recap, the VIX rose more than twice as fast as one would expect and is falling almost half as fast it has over the course of its history. That, in a nutshell, is the fear in the market. Another way of looking at the stubbornly high VIX is that investors do not believe the current rally is likely to be sustained, so options sellers are not marking down options prices with any sense of urgency, estimating that continued high implied volatility will persist.

Related posts:

Disclosure(s): short VIX at time of writing

Wednesday, August 10, 2011

VIX Backwardation Commentary

My recent VIX Term Structure Evolution Over Last Ten Days post seemed to draw a fair amount of interest from the Financial Times, Forbes and elsewhere, with some pundits claiming that the move from contango to backwardation in the VIX futures was foreshadowing everything from a “full-fledged bear market” to a “systemically important shock event.”

Just five days later, the VIX seems to have peaked, yet the amount of backwardation in the VIX futures term structure has actually increased. Looking at the front two months of VIX futures (which is where investors in the likes of VXX and XIV should be focusing), I note that the front month (August) is now 7.25 points higher than the second month (September) VIX futures. This positive roll yield means that investors who are short VXX and/or long XIV are losing almost 1% per day due to daily rebalancing (rolling) that involves selling the front month VIX futures and buying the second month contract.

This also means that should the VIX spike higher from current levels, ETNs such as VXX of TVIX and others should see enhanced returns due to an increase in volatility plus favorable term structure and roll yield.

One problem with backwardation is that it tends to be fleeting. Of the 59 instances of backwardation in the front and second month portion of the VIX futures term structure going back to the inception of VIX futures in 2004, 37% lasted only one day and 56% lasted no more than two days, fully 83% of all instances of backwardation had ended within six days and only six backwardation events in seven years have lasted more than the current eight days. Not surprisingly, three of those six periods of extended backwardation were from 2008, two were from 2009 and the last one was from 2007.

To state what I hope is the obvious, detailed knowledge of the workings of the VIX futures term structure is mandatory for anyone who trades VIX ETPs. Not only does one need to know what the implications are of the current term structure, but also to have a sense of how that term structure is likely to evolve over time.

Related posts:

Disclosure(s): long XIV; short VIX, VXX and TVIX at time of writing

Monday, August 8, 2011

VIX Sets Some New Records, Suggesting Volatility Near Peak

Just a week ago the VIX seemed to be lagging behind the growing investor anxiety about fundamental challenges facing the stock market, but after Thursday’s drop of 4.78% in the S&P 500 index and today’s decline of 6.66%, the doubling of the VIX to 48.00 in one week seems right in line with investor fear.  [Those wondering what a VIX of 48 means should consider that the literal translation is a prediction of a 3% or more change in SPX at least once every three days.  See Rule of 16 and VIX of 40 for a more detailed discussion.]

As the chart below shows, a VIX of 48 only puts the current crisis at #7 all-time – or at least dating back through VIX data since 1990. On a closing basis, today’s close was actually the highest closing VIX outside of the 2008-2009 financial crisis.

In studying my VIX data set, however, I was surprised to see that today the VIX set a number of new records. For instance, today marks the highest the VIX has ever closed relative to its 10-day, 20-day and 50-day simple moving averages. All three of these facts loom extremely large in terms of predicting future mean reversion behavior. In fact, I publish a proprietary VIX Mean Reversion Index each Wednesday for the benefit of my newsletter subscribers and today marks the first time that index has maxed out at 100.

I also have my own proprietary calculations for VIX fair value. Today my model puts VIX fair value in the mid-37s, which confirms what the VIX Mean Reversion Index is saying.

Of course the VIX is certainly capable of continuing to defy gravity for an extended period going forward, but the odds favor a top in volatility very soon and quite possibly at 48.00.  Just in the time it took to create this post the Dow Jones Industrial Average futures have swung several hundred points, so it is unrealistic to expect volatility to come to a screeching halt.

Better yet, fasten your seatbelts tomorrow, but don’t be afraid to short volatility.

Related posts:

short VIX at time of writing

Friday, August 5, 2011

VIX Term Structure Evolution Over Last Ten Days

If you think the last two weeks have turned the investing world upside down, well you have to look no farther than the VIX futures term structure to see just how accurate that view is. Two weeks ago the VIX was in the 17s and the VIX futures term structure was in contango (upward sloping) and today the VIX closed at 32 and the VIX futures term structure is in backwardation. In fact, the current VIX term structure looks a lot like a mirror image of what it was two weeks ago.

In the graphic below, I have detailed the shift in the term structure from July 22nd to today’s close. During that period, the S&P 500 index has sold off 10.8%, while the VIX has spiked 82.6%. Note that the front month (August) VIX futures have advanced sharply – up 59% during this period – but not as sharply as the VIX. Looking at the back end of the term structure, the March 2012 futures were not traded back on July 22nd, so the February futures are the most distant futures for which we can compare prices. Their move lagged the VIX and front month futures by a large margin and was almost identical in magnitude to that of the SPX, up 10.7% in those two weeks. One can clearly see from the funnel formed by the two term structure lines that for each month farther out in the term structure, the VIX futures were less responsive to the move in the SPX or the VIX.

In addition to annotating the backwardation and contango in the graphic, I have also circled the December VIX futures and options expiration (December 21st) in an effort to preempt some questions about why these futures seem unusually low both now and two weeks ago. The simple answer is the preponderance of holidays toward the end of the year, with fewer trading days translating into fewer opportunities for extended moves in volatility. I have discussed this phenomenon many times in the past (see VIX and the Week Before Christmas, for starters) and have named it the “holiday effect” or “calendar reversion.” Also note that December has a history of being relatively bullish for stocks, with low volatility.

Finally, I have fielded quite a few questions about the implications of yesterday’s 35.4% VIX spike. Here some prior research on the Short-Term and Long-Term Implications of the 30% VIX Spike will undoubtedly be of interest to most readers. The quick takeaway is that this event is bullish for stocks and bearish for volatility. I would expect to see more evidence of this fact beginning to kick in on Monday.

Related posts:

[source: Interactive Brokers]

short VIX at time of writing

Thursday, August 4, 2011

VIX Over 31 and SPX Down 12.5% From Peak as Bottom Nears

Calling bottoms in the stock market is part art and part science, but with the VIX closing over 31 today (up 35.4% to a close of 31.66) and the S&P 500 index having fallen 12.5% peak to trough from its early May high, the markets are likely nearing a bottom. Given that the SPX closed right at 1200, just above the intraday low, it is unreasonable to expect that a bottom is already in the books, but with today’s plunge, the process of finding a bottom has already begun.

Sure the problems with the European sovereign debt crisis seem to be at least one step ahead of the European Central Bank and there are widespread signs that economic growth is slowing across the globe, but a number of market sentiment indicators and technical factors suggest that the selloff in the past week has been overdone and way too emotional, perhaps with a healthy dose of forced selling in the mix. For some perspective, ask yourself just how bad tomorrow’s jobs number will have to be to prevent at least a relief rally from starting tomorrow.

As the table of SPX pullbacks below illustrates, the current selloff is the second sharpest in terms of magnitude since the bull market began in March 2009. It is now the longest in terms of duration, spanning 66 trading days since the high of SPX 1370.

Those who want to initiate new long positions in this environment may wish to limit risk by using options (long calls, bull call spreads, bull put spreads, etc.), but the time has come for the contrarian in the asbestos suit to start at least nibbling on the long side. Those with a more cautious demeanor may prefer to wait for some better evidence of a technical bottom and perhaps even a confirmation of that bottom, but while buying at current prices may risk being a little early, there is also a good chance that today’s sale prices will not be around for long.

[On a personal note, this blog has been quiet for a while as family matters, a vacation and three new computers have competed for my attention. With volatility back on the front page, I will be posting again on a daily basis (at least) in order to offer my perspective on the current spike in volatility, some of its causes and the implications for trading.]

Disclosure(s): none

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