Friday, August 17, 2012

What If Stocks Decline?

Successful investors are the ones that are always making plans for all sorts of contingencies, so it stands to reason that they should even prepare themselves for the possibility of stocks actually declining one of these days...

I was thinking about the coming correction in stocks and how to position my portfolio for that moment when equities once again feel the effects of gravity when I stumbled upon an interesting tool at that they call their Down Day Association Stats. In a nutshell, it looks at the performance of a group of user-specified exchange-traded products on those days in which a benchmark falls X%.

In the example below, I have chosen SPY as my benchmark, 2% (per day) as my threshold decline and 36 months as my lookback period. I looked at 25 ETPs that cover a wide range of asset classes and investment approaches.

Some of the results from the Down Day Association Stats are not particularly surprising. For instance, the long bond (TLT) and the dollar (UUP) have a strong negative correlation to stocks and generally perform well when SPY declines sharply. Some of the other bond choices (LQD, PCY, BWX) have been better at treading water than countertrending, but also show the benefits of diversification. The commodity choices were somewhat disappointing, generally managing to lose at best half as much as SPY, with crude oil almost matching the declines in the SPY to the penny.

Among the data points that surprised me were that the frontier ETF (FRN) fared better than the SPY in big down days, while real estate (IYR) fared worse.

Of course every decline in stocks has a different set of catalysts and puts different stresses on different asset classes, sectors and geographies, but as stocks continue to grind higher, be sure to make preparations for that eventual pullback, because when it finally does arrive, it will likely do so at an inconvenient time and with surprising swiftness.

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Disclosure(s): long LQD at time of writing

Thursday, August 16, 2012

A VIX Risk Reversal

With the VIX at about 14.50 as I type this and a large group of investors convinced that stocks are overbought and/or not properly discounting global macro risk, many are wondering just how to translate their beliefs into an effective trading strategy.

For those who think a long volatility trade is the answer, there is the issue of the significant contango headwinds, where a negative roll yield will pummel net asset values on VIX options and VIX exchange-traded products as a part of the daily rebalancing process, while VIX futures are subjected to a similar decay that reminds me a little bit of a dying helium balloon. Long story short: there is a huge daily penalty being assessed just for holding these long positions.

There are ways to minimize the effect of negative roll yield and typically one of the best of these is to work with positions that focus on the more distant months of the VIX futures term structure. This is generally why VXZ outperforms VXX over an extended period. Unfortunately for aficionados of VXZ, the negative roll yield between the fourth and seventh month VIX futures (VXZ buys the seventh month and sells the front month each day) hit a new record on Monday and continues at near record levels.

So what is a long volatility trader to do?

One trade that I somehow have never managed to highlight in my 5 ½ of writing about the VIX is a VIX risk reversal. A risk reversal is essentially a synthetic long position in which a trader uses options to create a position that is similar to owning the underlying, but typically ties up less capital in the process. In the case of a risk reversal, this means selling out-of-the-money puts and buying out-of-the-money calls. In many instances, the sale of the put options will finance 100% of the cost of the calls.

While the VIX is currently trading at 14.50, keep in mind that the best proxy for the price of the underlying for VIX options is the VIX futures for the corresponding month. So, with the September VIX futures at 18.95 at the moment, one could sell the September 18.00 puts for 1.50 and buy the September 24 calls for 1.05, pocketing the 0.45 differential. A more conservative trader might look to sell the VIX September 16 puts for 0.55 and use the proceeds to pick up a September 30 call for 0.55 or to defray some of the costs of the purchase of a more expensive call, such as the September 24 (priced at 1.05) mentioned above.

There are ways to turn this idea into a more aggressive trade as well. One approach is to morph a risk reversal into a leveraged trade in which more calls units are purchased than put units are sold. An example of this approach might involve selling the September 19 puts (which are currently at-the-money) for 2.15 and using the proceeds to purchase two contracts of the September 24 calls for 1.05 each.

A risk reversal also goes by other names, notably a long combination (or long combo) and, despite the name, is a high-risk trade that is vulnerable to the ravages of time decay. This trade is not for everyone, but can be a good way to generate significant long exposure with a minimal outlay of funds and sometimes no outlay of funds at all.

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Disclosure(s): long VIX at time of writing

Monday, August 13, 2012

How Can the VIX Be 14 and Lower than VIN and VIF?

Many novice and advanced VIX followers are scratching their heads today, wondering why the VIX is down more than 5%, hovering around the 14.00 level, when the SPX is down 0.4% and all the major market averages are deeply in the red. More serious students of the VIX will also note that this drop in the VIX comes on a Monday, when the typical VIX “calendar reversion” is generally responsible for about a 1% pop in the volatility index.

The answer to most of these questions lies in yet another idiosyncrasy of the VIX: the roll. Quoting directly from the source, the CBOE Volatility Index (VIX) White Paper, we find these two important nuggets from pages 4 and 9, which I have presented here sequentially for easier consumption:

“The components of VIX are near- and next-term put and call options, usually in the first and second SPX contract months. ‘Near-term options must have at least one week to expiration; a requirement intended to minimize pricing anomalies that might occur close to expiration. When the near-term options have less than a week to expiration, VIX ‘rolls’ to the second and third SPX contract months. For example, on the second Friday in June, VIX would be calculated using SPX options expiring in June and July. On the following Monday, July would replace June as the ‘near-term’ and August would replace July as the ‘next-term.’”

“At the time of the VIX ‘roll,’ both the near-term and next-term options have more than 30 days to expiration. The same formula is used to calculate the 30-day weighted average, but the result is an extrapolation of σ2 1 and σ2 2; i.e., the sum of the weights is still 1, but the near-term weight is greater than 1 and the next-term weight is negative (e.g., 1.25 and – 0.25).” [Emphasis added]

When I first posted about VIN and VIF back in March 2011 (VIN, VIF and an Obsolete VIX), I was stunned to learn how few investors, including savvy and experienced VIX fanatics, were completely unaware of these indices. At the time, the CBOE did not even refer to VIN and VIF on their web site, but they have since added a splash page for these two indices, along with the following brief comments:

CBOE maintains indexes that track the level of implied volatility from single SPX maturities.

Ticker VIN (VINX on Bloomberg) – nearer term SPX expiration used in VIX calculation

Ticker VIF – farther term SPX expiration used in VIX calculation

Getting back to the roll, the SPX options contract months roll forward one month today, so that the nearer-term month (VIN) moves from August to September and the farther-term month (VIF) moves from September to October. More importantly, per the bolded text from the VIX white paper above, today’s VIX calculations sum more than 100% of the VIN and a negative number for VIF. This is the reason why the VIX is less than the two components used in its calculation: VIN and VIF.  In summary, the bigger the difference between the VIN and the VIF (and right now that difference is a very large 9.4%), the more likely the VIX is going to be substantially depressed following the VIX roll.  Also, as we move toward the expiration of VIX options on August 22nd, the distortions from the negative VIF component used in the VIX calculations should gradually diminish, as the VIF weighting moves toward zero and then becomes a positive number.

For those who are interested in delving into the nuances of the VIX calculations, the CBOE’s VIX White Paper is the best place to start; the links below might also provide additional insight.

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Disclosure(s): long VIX at time of writing

Tuesday, August 7, 2012

Another Way to Play Short EUR/USD: Travel!

There are many ways to translate an opinion about the financial markets into a particular trade. Recently, I decided to act upon my belief that the euro would weaken against the dollar by booking a couple of weeks in Europe. The trader/VIXologist itinerary would have probably run something like Ireland > Portugal > Greece > Spain > Italy, but instead I elected to steer to the north, vising the Netherlands, Belgium, Luxembourg, Germany and the Czech Republic.

For the first time in many moons, parliamentary votes, etc., the markets were reasonably well behaved during my vacation and the VIX didn’t even make it into the 30s.

As someone who spends a great deal of time nine time zones away from the events behind the European headlines, I was somewhat surprised to see the relative calmness and lack of concern in the people I spoke with about the European sovereign debt crisis. This is not to say that the consensus was that the most difficult phases of the crisis were in the rear-view mirror, only that in due time, all would be sorted out and life would go on in a manner similar to the way it was prior to 2008.

That being said, I was surprised to see that in the sculptures above the Gate of Giants, which forms the entrance to Prague Castle, one forward-thinking artist had captured the essence of the discussions between the Troika and the Greek government…

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[photo: Gate of Giants, Prague Castle]

Disclosure(s): long VIX at time of writing

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