Implied Volatility as a Sector Drill Down Diagnostic

I have said relatively little about the crisis in the financial sector largely because there are so many others out there who are covering this story in much more detail than I have any desire to get into. Also, my trading is driven largely by technical analysis, charts and market sentiment, with fundamental analysis usually playing a prominent role only in my long-term holdings.

That being said, this blog has an emphasis on volatility and risk, so this morning I pulled up some implied volatility charts in the financial sector and drilled down from general to specific to see to what extent implied volatility might indicate vis-à-vis the possibility of the tide turning in investor fear. I have appended several of these charts below. On the left hand side, they include the generic large cap financial sector index, XLF (components), as well as the securities broker dealer index, XBD, whose volatility I analyzed back in August. On the right side, I have the banks. The BKX (components) is capitization-weighted and thus tilts toward money center banks; the KRX (components) has a strong regional and local focus; and the MFX (components), as the name suggests, includes banks and other financial companies that are heavily involved in the mortgage finance business. For comparison purposes, the BKX is down 18.7% on the year, the KRX is down 20.5% and the MFX is off 44.6%.

From an IV perspective (and yes, many of these companies could use some intravenous fluids) I generally glance at XLF only as a generic overview of the financial sector. The first finding of interest is that implied volatility in the XBD peaked in August and made a double top before Thanksgiving. This is consistent with the widespread belief that Goldman Sachs (GS) has dodged the subprime bullet and other players in this sector have had sufficient time and corporate agility – if not perhaps the ideal risk management policies – to limit any additional damage.

The banks are another story. Implied volatility in the money center banks and regional banks topped out at the end of November and is currently just below the August highs. Still more concerning, if not more surprising, is the performance of the mortgage finance sector, where implied volatility is above the August peak and in the process of challenging the late November high water mark. If I were a meteorologist looking at implied volatility, I would conclude that the storm has passed in the broker-dealer sector, but more thunderclouds are approaching in the regional banking and mortgage finance sectors.

Carrot Day

It has been a crazy few weeks of trading – and one of my most profitable stretches in at least a year – so I recently decided to reward myself with a couple of early holiday presents, as I am a firm believer that the lone wolf trader needs more carrots than sticks in order to achieve superior performance.

So today I am playing with my new Microsoft Zune 80GB (the first piece of Microsoft hardware I have ever purchased), waiting for AMC to unbox yet another laptop (I’m up to about two dozen since my Toshiba T1000), the HP dv2500t broadband wireless variant, and have already had a chance to thumb through Richard Bookstaber’s A Demon of Our Own Design. I’ll have to finish Alan Greenspan’s The Age of Turbulence before I get to Bookstaber, but Bookstaber certainly passes the ‘first paragraph test’ with flying colors:

“While it is not strictly true that I caused the two great financial crises of the late twentieth century – the 1987 stock market crash and the Long-Term Capital Management (LTCM) hedge fund debacle 11 years later – let’s just say I was in the vicinity. If Wall Street is the economy’s powerhouse, I was definitely one of the guys fiddling with the controls. My actions seemed insignificant at the time and certainly the consequences were unintended. You don’t deliberately obliterate hundreds of billions of dollars of investor money. And that is at the heart of this book – it is going to happen again. The financial markets that we have constructed are now so complex, and the speed of transactions so fast, that apparently isolated actions and even minor events can have catastrophic consequences.”

I’m still trading, but today is one of those days where I am mostly selling additional premium and watching time decay while I fiddle with my new toys. We all need carrot days, so be sure to take them when you earn them.

The VIX:VXV Ratio

Yesterday I talked a little bit about what the CBOE has said about the VXV. Even though it is still early days, today I thought I would offer up a simple framework that might be useful for using the VXV as a timing tool.

The chart below covers the first month of data from the VXV and calculates a ratio of the VIX to the VXV (the CBOE chart from yesterday chose to use the ratio of the VXV to the VIX, but I generally prefer to have the more volatile number in the numerator and the less volatile one in the denominator.)

I expect that the VIX to VXV ratio will make it easy to determine the extent to which the implied volatility on SPX options suggests investors expect volatility to rise or fall in the 30 day (VIX) to 93 day (VXV) time period. In addition to the 10 day simple moving average and 10% and 20% moving average envelopes, I have included three horizontal lines in the chart below. The dotted black line is set to 1.00 and indicates no expectations for a change in volatility over the 30 to 93 day time frame. The two solid black horizontal lines are set to 0.90 and 1.10 and are intended to be easy visual references to indicate when volatility is anticipated to change by at least 10% in that 30 to 93 day window.

The 10% level is somewhat arbitrary and largely dependent upon a desired signal to noise ratio, but it is supported by the CBOE data I highlighted yesterday and is consistent with much of my other research on the VIX. Just as is the case with VIX futures, I expect the VIX to have a tendency to fall and the markets to rise when the VIX:VXN ratio is above 1.10; and will look for the VIX to rise and the markets fall when the ratio is below 0.90, in classic mean reversion fashion.

Thinking About the VXV

I have recently received a couple of inquiries about the new VXV, which I first mentioned just after the CBOE launched the product in mid-November.

In short, whereas the VIX measures the implied volatility of SPX options 30 days out, the VXV measures IV for options 3 months (93 days) out. For those who want to get into the details of the VXV, the best source is a 6 page “Index Description” PDF published by the CBOE. In this paper, I found the following comments to be of particular interest:

“VXV has tended to be less volatile than 1-month VIX. Since January 2002, the volatility of VXV daily returns has been 58.4% compared to 90.1% for VIX. The correlation between VXV and 1-month VIX during that time was 0.92, indicating a strong tendency to move together, but far from moving in lockstep.

Using VXV and VIX together provides useful insight into the term structure of SPX option implied volatility. The following chart shows VXV price movement along with a measure of the difference between the 3-month VXV and 1-month VIX. Since January 2002, VXV has been higher than VIX – reflecting an upward sloping term structure – 79% of the time. However, 21% of the time, especially when volatility spikes, VIX is greater than VXV – reflecting a downward sloping term structure.”

Even better, the CBOE lays out what dedicated VIX and More readers could probably already have guessed:

“The behavior of VXV relative to VIX illustrates the mean-reverting properties of volatility and suggests that the slope of the 1- to 3-month SPX implied volatility term structure could be used to predict future levels of near-term (1-month) implied volatility...

When the VXV / VIX term structure was sharply upward sloping; that is, 3-month VXV was higher than 1-month VIX by more than 10%, the average closing VIX level over the following 20 trading days was, on average, higher by at least 5%. Moreover, this effect became more pronounced as the slope of the term structure steepened. Conversely, when the slope of the VXV / VIX term structure was relatively flat (less than 5%) or downward sloping (VXV lower than VIX), VIX levels over the next month tended to be lower, on average.”

All this can be neatly summarized in a CBOE graphic:

Now that we are coming up in one month of VXV data, I will start talking about this most interesting index on a regular basis.

Portfolio A1 Finishing Year With Big Gains

What was largely an up and down year for Portfolio A1 through Thanksgiving has suddenly turned out to be a very successful one, thanks to what is shaping up as a very strong finish. Essentially even on the year at Thanksgiving, Portfolio A1 is now up 19.3% just two weeks later, putting a lot of space between the portfolio and the benchmark S&P 500 index, which is now showing a 3.4% gain since the portfolio’s February 16^th inception.

While a bullish run in Sinopec (SNP) and a resurgent DryShips (DRYS) have helped, the 121% gain in Mosaic (MOS), added to the portfolio in mid-August, is the primary reason that the portfolio has made such impressive recent gains.

Given that the portfolio is putting up such superb numbers, I am inclined to reverse my previous thinking and continue to highlight it here past the end of the year, rather than start a new portfolio from scratch.

There are no changes to the portfolio this week.

A snapshot of the portfolio is as follows:

VWSI Holds at +3 Pre-FOMC

Last week the VIX fell 2.06 (9%) points to 20.85 after briefly trading below 20 for the first time since November 1^st.

Volatility has a tendency to spike up dramatically, but rarely does it decline in the same dramatic fashion. In fact, the successive weekly drops in the VIX 11.7% and 9.0% marks only the third instance since the March 2000 market top that the VIX has fallen at least 9% for two consecutive weeks. For mean reversion aficionados, the last four times the VIX has fallen at 9% or more two weeks in a row, in the subsequent week the VIX has changed +40%, +6%, +19%, and -3%.

While my portfolio is leaning in the bullish direction at the moment, the VWSI is holding steady at +3, a marginally bearish signal for the overall markets.

For a survey of the best in current thinking about the markets, Barry Ritholtz at The Big Picture sums up the week that was and the week that will be:

• December Linkfest: Week in Review
  
  
• December Linkfest: Week in Preview

While I wait for the Fed to make a decision on rates, I am in the process of reading Alan Greenspan’s The Age of Turbulence – an excellent read so far. One of the recurring themes in the book is how the resilience of the economy always seems to exceed his expectations. For more on the Fed, try my Fed Links.

(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. More recently, I was impressed by a 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.

Marc Allaire on VIX Options

I was only half kidding when I noted in the VIX and More disclaimer “Anyone wishing to trade VIX derivatives should have their head examined.” If you pick your spots, there are some great VIX setups out there, some of which Brian Overby recently highlighted and I summarized for the blog. VIX options can also provide relatively inexpensive portfolio insurance. The problem is that VIX options have many idiosyncrasies that make them much different from what even an experienced options trader might expect to encounter.

Today I see that Futures & Options Trader has included an article by Marc Allaire (author of The Options Strategist) on the subject of VIX Options on pages 16-19 of the current (December 2007) issue. Allaire is given enough space to get under the hood and offer up a fairly detailed treatment of VIX options. For those looking for a beginning to intermediate treatment of the subject, this is a good place to start. Fortunately, Futures & Options Trader is available free of charge in digital form. If you follow the link above, the logistics are self-explanatory. Note that these are the same people who also put out Active Trader Magazine.

Finally, if you are interested in an excellent free publication dedicated to VIX futures, I highly recommend the CBOE’s own Futures in Volatility monthly ezine.

A Year of the VIX

It was one year ago today that I decided to download the VIX historical data from the CBOE, dump it into Excel, do some quick and dirty analysis, then make some sort of determination about whether I should expend any additional time and energy studying market volatility.

One year later I am pleased to have taken that initial step, made a decision to expand the scope of my research, and little by little begun to incorporate some new ideas into my trading. Along the way, of course, a blog was born to collect and archive my semi-random thought tangents. After the first of the year, I will sit down at the keyboard and see what I can do in terms of distilling some of my thinking that is appropriate for publication and putting it here in blog-sized pieces, perhaps even in a more orderly fashion than the blog has evolved. Maybe I’ll begin with something like “VIX 101: An Introduction” or “A Dozen Things Everyone Should Know About the VIX” and go from there. Comments and suggestions, as always, are welcome.

In the meantime, I thought it might be interesting to assemble in one graphic the three charts iVolatility has for the VIX. These are the one year charts of the VIX price, the implied and historical volatility of VIX options (meta volatility), as well as the VIX options volume. I find it interesting to observe, among other things, the relationship between the VIX, VIX IV and VIX options volume.

Inverted VIX Still Bullish

The inverted VIX was such a big hit in its debut that I thought I maybe we should cut one more album, then go on tour, perhaps somewhere that we can get paid in euros…

For those that haven’t bothered to click through one of the links above, the inverted VIX chart below is generated by calculating the inverse of the VIX (1/VIX in mathematical terms) so that it can be plotted in such a manner that VIX tops tend to coincide with market tops and VIX bottoms with market bottoms. For fun, I have added a 50 week SMA to the weekly chart of the inverted VIX, along with an area chart of the SPX.

The result, particularly when looking at the current value of the inverted VIX relative to the 50 week SMA, suggests a market that has just begun to rebound and still has a long way to go before it starts to get overbought.

To be fair, if this turns out to be the beginning of a bear market, neither the VIX nor the inverted VIX is likely to be a particularly helpful intermediate or long-term timing tool, as a graph of the inverse VIX during the 2000-2003 bear market demonstrates. Until we start making lower highs and lower lows in the broader indices, however, the VIX will continue to be a helpful tool for determining when to buy on the dips.

Thinking Sideways But Volatile? Consider MCN…

Until further notice, I am going to consider this a sideways market instead of trying to guess whether the next big move will be up or down.

In terms of trading implications, this means selling volatility in the form of bear spreads, iron condors, iron butterflies, short strangles, short straddles, selling an occasional naked call, and even that old standby, covered calls.

If you are not a regular options seller, many of these strategies can seem daunting, risky, expensive, and a lot of work. While this can be the case, there is an easy way: a covered call fund or ETF. I have prominently mentioned BEP here in the past. BEP, also known as the S&P 500 Covered Call Fund, is a closed-end fund that does exactly what the fund’s name says. I am increasingly becoming more of a fan of another closed-end fund that is very similar: the Madison/Claymore Covered Call and Equity Strategy Fund (MCN). This fund trades a little more actively than BEP, appears to be a little more flexible in its investment approach than BEP, and carries a current dividend yield of 11.5%.

In a sideways market where investors fear a lot of volatility, I’ll take 11.5% and a chance to participate in an up move any day…

Christmas Shopping Strength: Luxury Purveyors vs. Discounters

Early data from the Christmas shopping season suggests that the consumer is more willing to spend than most pundits had anticipated.

In the deluge of December data to come, there will be answers to questions about how much consumers are spending, where they are buying, how important discounts are to their buying decisions, how much credit they are using, etc.

From a stock picking perspective, however, I am most interested in how upscale the purchases will be. Is this going to be a Tiffany’s (TIF) and Nordstrom (JWN) Christmas or will it be Zales (ZFC) and K-Mart (SHLD) under the tree? There are a number of ways to look at the high end vs. discounter equation, but I am going to offer up one that may simplify things a little.

Four months ago Claymore Advisors launched the Claymore/Robb Report Global Luxury Index ETF (ROB), with a list of holdings appropriate for those who own property on at least three continents. For the normal consumer, the S&P Retail Index has a much broader list of holdings that is more representative of where middle America shops. Combine the two and get one of those StockCharts.com ratio charts like the one below, which shows that for the past three months at least, luxury goods have held up nicely while the stocks of mainstream retailers have struggled in comparison. For the next three weeks in particular, this chart (or the free version) can serve as be a handy guide to determining which tier of retailer – and consumer – is suffering the most.

Portfolio A1 Moves Up Smartly

It was a very good week for Portfolio A1 – and an excellent week for the portfolio’s top three holdings. With Mosaic (MOS) gaining 13.4%, Sinopec (SNP) up 13.7%. and DryShips (DRYS) surging 22.8%, it is not surprising that the full portfolio tacked on 10.6% in a remarkable week.

With less than a month to go in the trading year, Portfolio A1’s cumulative 12.2% gain is 10.4% better than the meager 1.8% gain in the benchmark S&P 500 index.

Despite the recent success, the portfolio is not standing pat, as beverage company PepsiAmericas (PAS) is being swapped out for Fresh Del Monte Produce (FDP) in a move that I cannot attempt to explain. As fun as it has been watching and commenting on the doings of this mechanical portfolio, I am looking forward to rolling out a discretionary portfolio at the beginning of the new year.

There are no other changes to the portfolio this week.

A snapshot of the portfolio is as follows:

VWSI Rises to +3 as Volatility Wanes

The VWSI last hit +3 just eight weeks ago and prompted the headline VWSI Slips to +3; Pressure Builds for Correction. That correction arrived, but the bigger question is whether it is going to be taking a seasonal vacation this year. I suspect that this will not be the case and December will have more than the usual amount of fireworks, so I will be long dry gunpowder.

With a drop of 3.05 points or 11.7% to 22.91, the VIX had its lowest end of week close in five weeks, but I wouldn’t necessarily read too much into these data points. Ultimately it is what the markets do at major support levels that will determine how volatile we are going forward and not volatility that will wag the dog.

For a survey of the best in current thinking about the markets, Barry Ritholtz at The Big Picture sums up the week that was and the week that will be:

• December Linkfest: Week in Review
  
  
• December Linkfest: Week in Preview

Looking ahead, for those with an interest in the COT report, note that the commercials have been getting long volatility as of late. While the track record of this group is not great, it is better than most, so their actions bear watching.

(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. More recently, I was impressed by a 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.

New Blog/Site Recommendation: Index Indicators

It is rare that I go out of my way to devote an entire post to a particular blog or web site, but in the case of IndexIndicators.com this type of attention seems warranted, even though the web site is only in the second week of its life.

First things first, a tip of the hat to Headline Charts, which is already incorporating some Index Indicators charts into the site's weekly Friday Market Sentiment report, which should be a mandatory stop for brushing up on the latest in various market sentiment surveys and related data.

Of particular interest to VIX and More readers will likely be the Index Indicators market commentary blog and the wide variety of charts they provide for breadth indicators, put to call ratio indicators and volatility indicators.

Charts are of the end of day variety, range from three months to three years, and include the following information:

• Breadth indicators – % of stocks above their 5, 10, 20, 50 and 200 day SMAs; also % of stocks whose 5, 10, 14, and 21 day RSIs are above 70 or below 30
  
  
• Put to call ratio indicators – the 5, 10 and 20 day SMAs for the CBOE equity, index and total put to call ratios
  
  
• Volatility indicators – the 5, 10, 20, 50 and 200 day SMAs for the VIX, VXO and VXN, plus the current level of each of these indices relative to these SMAs (see below for one such chart)

In sum, this new site is an excellent source for data and charts on three subjects that are central to my trading and to the blog as well. For this reason, I have also added IndexIndicators.com to the “VIX & Sentiment Links” in the upper right hand section of the blog.

The Promethian Trader

I may be projecting a little here, but I suspect that most who are new to trading generally approach the subject as a problem largely consisting of how to build and implement a consistently profitable trading system.

While there are several excellent blogs that deal largely with the trader’s personality (most notably Brett Steenbarger’s TraderFeed and Corey Rosenblum’s Afraid to Trade), I have yet to say much of anything on this subject, even though I am strongly of the opinion that eventually all traders will realize psychology is the most important part of trading, even those who are using mechanical systems. In Trade Your Way to Financial Freedom, noted author and trading consultant (and occasional blogger too) Van Tharp puts it this way:

“When I’ve had discussions about what’s important to trading, three areas typically come up: psychology, money management (i.e., position sizing), and system development. Most people emphasize system development and de-emphasize the other two topics. More sophisticated people suggest that all three aspects are important, but that psychology is the most important (about 60%), position sizing is the next most important (about 30%), and system development is the least important (about 10%).”

With this in mind, I was most interested to recently discover that Tharp had published an eight part series outlining some of his thoughts on personality types and trading. For those who may still be skeptical of the importance of psychology, before dismissing the articles, be sure to jump down to Part Eight, where Tharp talks about the Promethian Temperament. Tharp tosses out two statistics that I found particularly interesting:

1. The Promethian Temperament (xNTx in Myers-Briggs speak) occurs in his sample trader population at a rate more than twenty times that of the general population; and
2. “Among our NT traders, about 10% show outstanding trading records—a higher percentage than any of the other temperaments.”

Tharp goes on to explain that despite the fact that NT traders are handicapped by a strong desire to predict, control and explain the markets, they overcome this and are successful as a result of their insistence on acquiring more self-knowledge, continuously improving their craft, and applying as much science as possible to potential trading approaches.

If you are an NT, as I am, you probably know all of this already, but you might want to read the article closely to look for the shortcomings that NTs are prone to. If you are not an NT trader, consider how your Myers-Briggs personality type my help to accelerate and simplify the process of identifying your potential strengths and weaknesses as a trader.