More on VIX Futures and Volatility Expectations

Don’t tell anyone, but I call these my “More on…” posts because I can be headline-challenged at times...

Moving right along, thanks to an anonymous poster who reminded me that FutureSource.com has excellent free futures data, including intra-day quotes. Since I last checked out their site, they have considerably expanded the information available on the VIX and the newer volatility futures. For easy reference, I have added a link the FutureSource.com volatility futures quotes in the upper right hand corner of the blog.

Yesterday I posted a CBOE chart of the VIX futures data out through August 2008 that showed VIX futures pricing in increased volatility over the next ten months, with most of that priced in as short-term mean reversion anticipated during the November options/futures expiration cycle.

Expanding on that theme somewhat, today’s chart compares the life of June 2008 VIX futures (VX-M8 CF) to the cash VIX for the past year. While you would expect the cash VIX to be considerably more volatile than a futures contract 8-12 months out (recall the February 26-27 cash vs. futures VIX action) this was not the case during the July through August VIX spike and only began to become apparent by the higher readings that persisted in the June 2008 futures after the cash VIX began to subside. What I find particularly interesting about the current situation is that once the cash VIX dropped below 21.00 and kept dropping all the way down to the 16.08 reading earlier today, the June 2008 futures refused to follow. The two different Y-axes somewhat obscures the absolute numbers involved here, but the key takeaway – that of an increasing divergence over the past month – is hard to miss.

It should come as no surprise that the futures and the VWSI are saying the same thing. Once again, the big questions are how long it will take for the spread between the cash VIX and futures VIX to narrow and whether it will be more of a rising cash VIX or a declining futures VIX that will be responsible for a narrowing spread.

VIX Futures and Volatility Expectations

Periodically, I get a question about where to find VIX futures data. A few brokers (optionsXpress is one) have this information available via their web site and/or trading platform. The CBOE also provides VIX futures data at no charge through the CBOE Futures Exchange (CFE). Follow the link provided and click on the “Price and Volume Detail” tab to get information on all the VIX futures contracts for the previous trading day. The CFE also has a Historical Market Data page for those who are interested in detailed historical statistics.

I have clipped a snapshot of yesterday’s closing data to give a sense of what information is available. Note that most of the action is in the front three months, yesterdays futures were pricing in an 0.94 gain (a 17.06 futures settlement price vs. a 16.12 close in the VIX cash price) in the VIX over the next five days (October contracts expire a week from today), and volatility expectations from November 2007 to August 2008 are fairly uniform and muted.

If we do see volatility return to the markets soon, as I anticipate, I will compare a snapshot of VIX futures then with the current picture.

When to Short China?

Eventually, there will come a time when you will look back and say to yourself, “Why wasn’t I short China? It was such a no-brainer…” The answer to that question has a lot to do with the dictum that the markets can stay irrational much longer than many of us can stay solvent. Ask anyone who was short tech stocks in 1999 and knew it was just a matter of time before they were proven right.

There are a number of ways to approach this problem, but ultimately you want to be short when the majority stops buying on the dips and starts selling into the rallies. When does this happen? Generally, when the short-term moving averages (such as the 10 day SMA) start to roll over and slip below the intermediate-term moving averages (i.e. the 65 day SMA) distribution is occurring.

In that same vein, ratio charts can be helpful to spot speculative trends as well. Keep your eye on the relative performance of the FXI versus the NASDAQ and remember that it is better to catch the easy middle part of the move than to call the turning points. Traders should aim for the easy money; let the so-called gurus (and bloggers) shoot for bragging rights and the easy headlines…

Goldman Sachs (GS) Hits New All-Time High

In case anyone was wondering, this means the looming financial crisis has officially been canceled.

As much as various sentiment indicators suggest that there is too much froth in the markets, that doesn't mean it is a good time to be short. Said another way, never try to anticipate when a fast moving locomotive will make a U-turn, but be nimble enough to grab onto the caboose as it goes by, regardless of the direction...

ISEE Highlights Froth

Just in case it is not already obvious to anyone who may be an occasional reader, the VIX and the ISEE are my two favorite measures of market sentiment.

Right now the VIX is suggesting that the current market environment is overheated. This is evident in measures such as the distance the VIX is below various moving averages, the VWSI, and the VIX:SDS ratio.

Until recently, the ISEE was a little more prone to fence-sitting, but that changed with yesterday’s 187 reading, the highest single day reading since August 2006. On the heels of that large number comes a wave of call buying this morning that has the ISEE at 270 as of 11:10 EDT. Now it is not unusual to see extreme readings in the ISEE early in the day, when the denominator is low, but what is unusual is to see those extreme readings get even more extreme as the day wears on, such as the ISEE actually jumping up from 257 to 270 during the last 40 minutes. This development bears watching…

Schaeffer Thinks VIX May Be Signaling ‘All Clear’

In today’s Monday Morning Outlook: Small Cap Sentiment and a Significant VIX Move, Bernie Schaeffer opines that last week’s VIX close below the 32-week simple moving average could signal the same sort of “all clear” message that a similar VIX close did in August 2006.

On the SPX-VIX correlation front, Schaeffer also looked at Friday’s action and noted that “the SPX rallying more than 0.85% while the VIX drops less than 10% - has had historically bullish implications dating back to 1990. Specifically, after 20 days the market is higher 69% of the time; the average gain in the SPX over this period is 1.65%.”

As an aside, readers may be interested to know that I have provided links on the right hand column of the blog to several important voices who frequently talk about the VIX and market sentiment. The links to “Other Important Voices” can be found just below “Blogs I Frequent” section and currently includes the likes of Bernie Schaeffer, Larry Connors, Fred Ruffy, Jay Kaeppel, and Mark Hulbert.

Top 10 Forecasts from ‘The Futurist’ Magazine

I have highlighted the top ten forecasts from The Futurist magazine below. More details, references, and additional information are available from Outlook 2008, an annual collection of “the most thought-provoking ideas and forecasts” appearing in the magazine.

While I generally measure my investment time horizon in days, it always pays to be thinking several years ahead.

1. The world will have a billion millionaires by 2025. Globalization and technological innovation are driving this increased prosperity. But challenges to prosperity will also become more acute, such as water shortages that will affect two-thirds of world population by 2025.
   
   
2. Fashion will go wired as technologies and tastes converge to revolutionize the textile industry. Researchers in smart fabrics and intelligent textiles (SFIT) are working with the fashion industry to bring us color-changing or perfume-emitting jeans, wristwatches that work as digital wallets, and running shoes like the Nike +iPod that watch where you're going (possibly allowing others to do the same). Powering these gizmos remains a key obstacle. But industry watchers estimate that a $400 million market for SFIT is already in place and predict that smart fabrics could revitalize the U.S. and European textile industry.
   
   
3. The threat of another cold war with China, Russia, or both could replace terrorism as the chief foreign-policy concern of the United States. Scenarios for what a war with China or Russia would look like make the clashes and wars in which the United States is now involved seem insignificant. The power of radical jihadists is trivial compared with Soviet missile capabilities, for instance. The focus of U.S. foreign policy should thus be on preventing an engagement among Great Powers.
   
   
4. Counterfeiting of currency will proliferate, driving the move toward a cashless society. Sophisticated new optical scanning technologies could, in the next five years, be a boon for currency counterfeiters, so societies are increasingly putting aside their privacy fears about going cashless. Meanwhile, cashless technologies are improving, making them far easier and safer to use.
   
   
5. The earth is on the verge of a significant extinction event. The twenty-first century could witness a biodiversity collapse 100 to 1,000 times greater than any previous extinction since the dawn of humanity, according to the World Resources Institute. Protecting biodiversity in a time of increased resource consumption, overpopulation, and environmental degradation will require continued sacrifice on the part of local, often impoverished communities. Experts contend that incorporating local communities' economic interests into conservation plans will be essential to species protection in the next century.
   
   
6. Water will be in the twenty-first century what oil was in the twentieth century. Global fresh water shortages and drought conditions are spreading in both the developed and developing world. In response, the dry state of California is building 13 desalination plants that could provide 10%-20% of the state's water in the next two decades. Desalination will become more mainstream by 2020.
   
   
7. World population by 2050 may grow larger than previously expected, due in part to healthier, longer-living people. Slower than expected declines of fertility in developing countries and increasing longevity in richer countries are contributing to a higher rate of population growth. As a result, the UN has increased its forecast for global population from 9.1 billion people by 2050 to 9.2 billion.
   
   
8. The number of Africans imperiled by floods will grow 70-fold by 2080. The rapid urbanization taking place throughout much of Africa makes flooding particularly dangerous, altering the natural flow of water and cutting off escape routes. If global sea levels rise by the predicted 38 cm by 2080, the number of Africans affected by floods will grow from 1 million to 70 million.
   
   
9. Rising prices for natural resources could lead to a full-scale rush to develop the Arctic. Not just oil and natural gas, but also the Arctic's supplies of nickel, copper, zinc, coal, freshwater, forests, and of course fish are highly coveted by the global economy. Whether the Arctic states tighten control over these commodities or find equitable and sustainable ways to share them will be a major political challenge in the decades ahead.
   
   
10. More decisions will be made by nonhuman entities. Electronically enabled teams in networks, robots with artificial intelligence, and other noncarbon life-forms will make financial, health, educational, and even political decisions for us. Reason: Technologies are increasing the complexity of our lives and human workers' competency is not keeping pace well enough to avoid disasters due to human error.

Portfolio A1 Reconsiders DryShips (DRYS)

Last week I expressed my surprise that the portfolio had decided to sell out its position in DryShips (DRYS) after the stock registered a 27% gain in just four weeks in the portfolio. In retrospect, my skepticism looks warranted, as DRYS logged an 8.9% gain last week, while the stock it was replaced with, Shanda Interactive (SNDA), was only able to add 0.3% during the week. That differential, which meant a net of about 1.7% to Portfolio A1 last week, accounts for all of the 1.4% lost relative to the benchmark S&P 500 index last week.

Ironically, Portfolio A1’s stock ranking system has reconsidered this week and decided to add DryShips (DRYS) once again, while dropping the one other stock that has had two round trips in the portfolio: Terex (TEX).

While Portfolio A1 continues to try to run down the S&P 500, I am refining the next iteration of my public portfolio in the background and am readying for a January 1, 2008 launch. One of the most important changes is that this portfolio will not be a 100% mechanical system. It will be partly discretionary, so that I will be able to make decisions along the lines of overriding a sell signal in DRYS, if I don’t think it is appropriate.

There are no other changes to the portfolio this week.

A snapshot of the portfolio is as follows:

VWSI Slips to +3; Pressure Builds for Correction

The word ‘correction’ implies that something is wrong that needs to be corrected. Even though I spent a good portion of last week on the wrong side of the markets, that doesn’t make the markets wrong, it merely makes me wrong.

Still, the persistent high positive numbers registered in the VWSI over the past three weeks is unprecedented, which is part of why I have been wrong side of the market. While the VWSI and VIX are excellent short-term indicators, they are far from omniscient.

Strictly by the numbers, the VIX registered its fourth consecutive substantial weekly drop last week, losing 1.09 or 6.1% to end the week at 16.91. This is the lowest end of week reading in three months and raises the question of where the VIX will ultimately find a bottom. I recently attempted to answer this question; and Adam Warner at Daily Options Report had some similar thoughts on the subject.

(Note that in the above temperature gauge, the "bullish" and "bearish" labels apply to the VIX, not to the broader markets, which are usually negatively correlated with the VIX.)

Wine pairing: For previous VWSI readings of +3, I highlighted sauvignon blancs from Cloudy Bay and the Marlborough region of New Zealand, as well as some excellent California producers whose sauvignon blanc can be had locally for $10 or less: Bogle; Chateau St. Jean (where it goes under the fumé blanc moniker); Concannon; Kenwood; and Sterling. This time around, I recommend an elegant, complex sauvignon blanc, with a little bit of oak, from Gary Farrell Vineyards. Their 2005 effort can be had for about $25; for my money, it knocks the socks off almost all of the chardonnays in that price range.

Finally, for an entertaining (think the mannerisms of Joe Pesci and Woody Allen blended with the enthusiasm of Jim Cramer) and informative look at sauvignon blanc, I encourage the reader to sample Gary Vaynerchuk's "Sauvignon Blanc Taste-Off" on wine library tv.

Where Will the VIX Find a Bottom?

Let me start out by stating for the record that I have no idea whether it is appropriate to use traditional charting and other technical analysis techniques to attempt to determine support and resistance levels for the VIX. After all, the VIX is a multi-generational derivative that is a good distance removed from reality. For purposes of simplification, think of the VIX as a shadow puppet (more accurately, the composite shadow puppet from 500 simultaneous light sources); if we want to learn more about it, should we study the shadows or consider the hands from which the shadows are cast? I have a tendency to talk about the shadows, but for charting purposes I am inclined to believe that they are still just shadows.

So…with that backhanded disclaimer out of the way, let me turn my attention to a VIX that just made an intra-day low of 16.63. Whether that number sounds high or low depends upon where you have been anchoring a ‘normal’ price in your mind. At 16.63, the VIX is 68% above the year’s low (9.87), 56% below the year’s high (37.50), and about 7% above the VIX’s lifetime mean, which stands at 18.93.

I recently made a guesstimate that the VIX would bottom in the 16-17 range in October and I have no reason to depart from that thinking. I will, however, offer the weekly chart of the VIX below as one way to think about that 16-17 support range. Instead of the long-term moving averages (which may look interesting, but are of dubious value), focus instead on the Williams %R number. When the %R crosses below -80, it has a tendency to signal a bottoming out in the VIX – to the extent that you can tell when a shadow puppet is bottoming out…

SPX-VIX Correlation Nugget

I’ve been banging the SPX-VIX correlation drum fairly hard lately, so it’s time I moved on to other things.

Before I do, however, I will point the reader to a previous post in which I laid out some of my thinking on the significance of the correlation. I think the title says it all: “High Positive Correlation Between VIX and SPX Often Signals Market Weakness.”

There is also the issue of recent correlation data. For the past week and a half or so, the SPX and VIX have had an unusually high positive correlation, at least relative to historical data. In fact, the last time the SPX and VIX showed correlation levels this high for several days running it was…February 22, 2007, just three days before the largest VIX spike since the CBOE began tracking the VIX in 1990. Now before anyone jumps to conclusions, none of the eight previous correlation ‘spikes’ of comparable magnitude from the current decade resulted in a significant move in the SPX, so the historical record has to be considered ambiguous at best in the current environment.

SPX-VIX Daily Correlation

Yesterday I offered up some numbers to help describe the relationship between daily moves in the SPX and the VIX. I hear quite a few observers comment along the lines of “the SPX was up(down) X% and yet the VIX was only down(up) Y%.” Typically, the next action is to wonder aloud whether the corresponding VIX movement is ‘normal’ and whether any divergences might provide clues about the future direction of the markets.

Naturally, I’ll take the easy part of that equation first and offer the reader two ways to look at this. The graph below plots daily percentage changes in the VIX against daily percentage changes in the SPX. From the graphic, you can see that the relationship between the two is fairly linear for a SPX moving +/- 1.5% in a day. Once the SPX moves outside of those bounds, however, the equations get a little messier. Part of this, of course, is the accelerating fear factor that comes with extreme market moves.

The next graph ignores the absolute numbers and focuses on the magnitude of the typical VIX movement versus the SPX movement. Readers are encouraged to ignore the valley around the zero (where strange things happen when you try to divide by zero) and focus instead on the fairly predictable ratio of the VIX to SPX that varies from about -2.5x to about -5.0x, depending upon the daily change in the SPX.

As for the remaining question about whether divergences from the normal relationship provide reliable clues about the future direction of the market, I am going to address this more difficult question over the course of the lifetime of this blog. I will offer this though: if I think I can simplify the answer in one concise post, I will do the best I can to communicate my thinking here.

More Thoughts and Numbers on the SPX-VIX Correlation

I have used this space to talk about the correlation between the VIX and SPX, the SPX:VIX ratio and an bunch of other related subjects. Some may be ready to scream “Enough already!” but now it’s time we really got serious about the subject.

Let’s start with yesterday. There was a lot of talk (if you travel in certain blogging circles, at least) about how unusual it was for the SPX to jump 1.33% while the VIX moved down only 0.89%. The contention that the move on the part of the VIX was rather tepid seems to make sense in theory, because it is ‘common knowledge’ that the VIX typically moves in the opposite direction of the SPX and at a much faster rate. Where are the numbers to support this belief? Well, I’m going to start trotting them out in this space, but not all at once, so that I everyone has a chance to move to higher ground before the flood hits.

Some numbers to contemplate, using data from 1990:

• The VIX and the SPX move in the opposite direction on 76% of all trading days
• On those days the VIX and SPX move in the same direction, the move is more likely to be up than down
• In percentage terms, the median daily move in the VIX is -4.2x the daily move in the SPX

Getting back to yesterday, the SPX has risen 1.33% on seven previous instances. On all seven occasions when the SPX has risen 1.33%, the VIX has dropped, with a mean drop of 6.3%, a maximum of 10.1% and a minimum of 1.4%. Of those seven previous instances, the SPX recorded the largest subsequent gains (10, 20 and 50 days out) when the VIX dropped the farthest (10.1%); the SPX had the worst subsequent performance (10, 20 and 50 days out) when the VIX dropped the least (1.4%.) I know this is just seven data points, but history is not looking favorably on yesterday’s VIX performance.

I’ll have a lot more to say about this subject, with a lot more statistical significance, in the near future.

Quiet Before the Storm?

Though the most recent installment was published last Friday, I would be remiss in not highlighting the work done by Fred Ruffy at Optionetics.com. Fred authors a weekly Sentiment Journal that covers many of the issues I touch on here, with a mixture of charts, tables and text in an effort to summarize the week that was and provide some insights into the coming week.

Ruffy's most recent entry bears the title Quiet Before the Storm? He looks at much of the same data that interests me and we reach many of the same conclusions, mostly cautionary, about the current state of the markets. For the record, even with today's continued market strength, I find myself net short the markets (and long volatility) for the first time in 2007.

Finally, for those who may be interested, Fred also fields questions at Optionetics on their Ask Fred Ruffy discussion board.

Portfolio A1 Jumps 5% in Week

As the equity curve below shows, the August plunge has largely been eradicated in September, thanks in part to an impressive 5% gain in the portfolio last week. The strong week puts Portfolio A1’s cumulative return back into the plus column, with gains since the February 16^th inception now at 1.8%. While this performance continues to trail the 4.9% gain registered by the benchmark S&P 500 index during the same period, an optimist might venture a small smile for the first time in about two months.

One unusual aspect to last week’s gains is the decision by the stock ranking system to drop DryShips (DRYS) after a stunning 27% gain in just four weeks in the portfolio. This is the first time the portfolio has dropped a double digit gainer and it is a little bit of a head scratcher, but perhaps the stock ranker has turned HAL on me taken up to reading Investor’s Business Daily, specifically a Friday article titled Smiling Dry-Bulk Shippers See The Boom Times Lasting For Years.

To replace DryShips, the portfolio has decided to dive headlong into China by picking up Shanda Interactive (SNDA), the Shanghai-based interactive entertainment company. In my discretionary trading I am short China stocks at the moment, so this portfolio may provide yet another interesting competition between man and machine.

There are no other changes to the portfolio this week.

A snapshot of the portfolio is as follows: