VIX Spikes and SPX Drops Are Not Necessarily Two Sides of the Same Coin

Friday was a day in which the VIX spiked 26.5% and the SPX dropped 3.1%. On the surface, that does not sound unusual: the market plunges and the VIX simultaneously spikes in the opposite direction as sellers get a little panicky.

Over the weekend, I was reviewing the performance of the SPX after a 3% drop and saw the classic mean reversion pattern of a market that usually does very well after a big one day selloff. I looked at the VIX and noticed an even more predictable pattern of mean reversion following a VIX spike. Again, this is what is what you might expect -- particularly if you spend a lot of time with this data, as I do.

Then I saw something that I was sure had to be some sort of mistake: when the VIX spikes 20% or more in one day (see Adam at Daily Options Report for his thoughts on this phenomenon), the VIX reverts, but the SPX does not tend to perform particularly well going forward. But how can this be? I had just looked at data I had crunched to show that following a SPX drop of 3%, the index had a history of exceeding ‘normal’ performance by three to ten times over the course of the next few weeks and months.

As it turns out, prior to Friday, there are 27 instances since January 1990 in which the VIX has spiked 20% or more in a single day. As luck would have it, there are also exactly 27 instances in which the SPX has dropped 3% in a single day during that period. It turns out, however, that only 8 of those 27 instances are the same session. In analyzing the data, I have come to the conclusion that as a rule, the 3% drops in the SPX are better indicators of a future bounce in the SPX than the 20% drops in the VIX. I will be sure to elaborate more on this observation going forward, but thought I should offer up this conclusion this morning for those who are still wondering about whether Friday’s session has bullish or bearish implications.

A Long-Term View of the Put to Call Ratio

Of all the trading/investing blogs that have arrived on the scene in 2008, I think my favorite is Rob Hanna’s Quantifiable Edges. The title pretty much sums up the blog’s approach. This is a place where Rob analyzes the markets, observes various relationships that lie hidden under the surface for most investors, extracts some insight, and back tests these ideas to determine their historical profit potential.

Today Rob takes a slightly different approach, as the Celtics-Lakers game appears to have depleted his overnight R&D staff. Instead, in Why You Need to Normalize the Put to Call Ratio, Rob posts a graphic that looks a lot like the night sky (the bottom section of the first graphic, below), but actually comprises 12 years of the CBOE Total Put to Call ratio.

Rob conclusions mirror much of my own thinking and are worth capturing in detail:

“Often times I hear traders refer to absolute levels in put/call ratios as if they are significant. What you can see by looking at the chart above is that ‘significant’ has change over time. From ’97 to ’02 a ‘spike’ in the ratio over 1.00 could have been viewed as significant. A trader seeing such a reading may conclude that fear among option traders was running high. Now a reading of 1.00 is below average. A reading of 0.5 would sure be significant, though. In 2000 it was about average. Strategies that may have been developed 7 or 8 years ago that looked for a move to a certain number are now likely obsolete. That doesn’t mean the put/call ratio has stopped working as an indicator, though.

The issue lies in the fact that the popularity and use of options for traders and institutions has changed over time. It will continue to change. To adjust for this you should normalize the readings over a certain time period and then compare the current readings to ‘normal’.”

Just for fun, I have appended a StockCharts.com graph of the SPX to the top of Rob’s TradeStation chart of the put to call ratio. It may resemble a visual Minotaur of sorts, but the result shows an almost perfect negative correlation between the put to call ratio and the SPX from the mid-1990s through the end of 2003. Then, without warning, the correlation shifts from a negative one to a positive one from 2004 to 2008, before reverting to the traditional negative correlation pattern for the last six months or so.

In the graphic at the bottom, I have done my best to fit a weekly chart of the total put to call ratio into an absolute scale that provides meaningful buy and sell signals. There are a number of ways to look at this chart. The first thing to do is to acknowledge that there is no place in the chart where meaningful buy and sell signals were generated in the same general time frame. A second possible takeaway is that on those occasions when the P/C levels were below the red sell line or above the green buy line for an extended period of time, this could have been a signal (and an helpful one, in retrospect) to be short from 1999-2001 and long from 2005-2008. Finally, while not spelled out on the chart, one can see how tracking the deviation between the 6 week EMA shown with a dotted blue line and a long-term (i.e., 40-50 week) moving average (not shown) could provide an actionable synthesis of the need to measure absolute and relative levels of the put to call ratio.

Something to think about, at least, while watching the Celtics and Lakers…

Schaeffer on the Volatility of the VIX

Bernie Schaeffer is out with another interesting take on the VIX today. In Schaeffer’s Short Takes: The Volatility of the VIX (may require free registration), he offers some compelling data and charts on the historical volatility of the VIX.

The charts make for good reading, but it is Schaeffer’s conclusion that I wish to focus on:

“From a sentiment perspective, one might conclude that a high ‘second derivative VIX’ is an indication of excessive bearishness. At the very least one can reasonably conclude that if the protection trade is in fact crowded, then the chances of a major downside accident are significantly reduced as big money is already down on the black swan event.”

The important point is that the more downside protection that investors load up on (using VIX calls or by buying puts on other indices), the less impact any downturn will have. In other words, there will be little in the way of a vicious cycle of selling if options are mitigating losses from a bear move. By the same token, a black swan event, by definition, has to be a surprise. If investors are prepared for the beast, then it will have to arrive in another form, if it arrives at all.

As an aside, I don’t believe the term ‘second derivative VIX’ is the best phrase to use when speaking about the historical volatility of the VIX. The VIX is the implied volatility of the SPX, so a second derivative would logically refer to the implied volatility of the VIX, something I have labeled meta volatility in this space in the past. While technically one can derive both historical and implied volatility from the VIX, mixing historical volatility and implied volatility together in this context muddies the already murky waters of what a VIX derivative is.

It sounds like it is about time for another VIX 101 post to clarify some of this…

The VIX and Sectors: A One Day Snapshot

I collect a lot of strange and unusual data in the course of trying to be “Your One Stop VIX-Centric View of the Universe…” and it makes sense to share some of those chunks of data from time to time, even when I don’t think it will change the way anyone looks at the market.

Now that I’ve lowered your expectations, I call your attention to the graphic below, which captures the movements in the various sector SPDRs over the course of Monday to Tuesday, a day in which rumors of persistent difficulties at Lehman Brothers (LEH) helped to drag down the financial sector ETF (XLF) to its lowest level since March. The sectors are ordered with the highest weighted ETF at the top (XLK - technology) and the lowest weighted (XLU - utilities) at the bottom. With any luck, the balance of the graphic is self-explanatory.

From a sector and volatility perspective, I found a few interesting tidbits from the graphic. First of all, the change in the VIX and the change in the SPX implied volatility were almost identical, which is what you would expect. I did find it interesting that the VIX jumped more than twice the percentage change in the mean IV across the nine sector ETFs. Drilling down a little more, only three of the sectors had an increase in IV that was higher than the jump in the VIX -- and in each instance this was just barely the case.

I have highlighted in green the two sectors in which the price of the ETF increased at the same time that implied volatility increased. For the consumer discretionary sector (XLY), the change is not particularly dramatic, but for the materials sector (XLB), there is a substantial jump in IV on the heels of increasing price. Needless to say, this is unusual.

Part of the explanation for the large increase in the VIX (and SPX IV) relative to the individual sectors may come from the fact that the four most heavily weighted sector ETFs all had a substantial rise in IV, but even when taking this into consideration, the change in the VIX exceeds the change in the sum of the weighted parts.

Finally, for anyone who followed my fearogram and SPX-VIX correlation analysis last year, you may recall that the median daily percentage move in the VIX is -4.2x of the daily move in the SPX. For the record, yesterday the VIX moved 3.6x in the opposite direction of the SPX. In percentage terms, this is a fairly typical negative daily correlation number. [Disclosure: Long LEH at time of writing.]

CBOE Equity Put to Call Ratio Looking Bullish

Based on one of the ways I like to apply the CBOE Equity Put to Call Ratio, this ratio has just turned bullish for the first time since late April. Like any indicator, put to call ratios are far from infallible, but looking at historical context, there is a good possibility that the recent surge in put activity will be enough bricks in the wall of worry to provide a base for another bullish move from current levels.

Given that most of the other indicators I follow have a more neutral outlook, it will be interesting to see how this plays out.

Lehman Teetering Again

I would love to be able to dismiss out of hand the various rumors that have been circulating about Lehman Brothers (LEH) over the course of the past few weeks. The fact is that Lehman seems to be unable to escape the Pig-Penesque cloud that has hung over the stock since the demise of Bear Stearns.

Lehman Brothers is down another 3% to 35.59 as I write this, with the prospect of another test of last week’s 35.00 support level coming soon. If 35.00 fails to contain the current round of selling, this could get ugly quickly and raise more questions about counterparty risk. I don’t like the looks of the LEH chart; clearly they are a long way from being out of the woods.

Subscriber Newsletter Portfolio Performance through May

As I hinted at yesterday in Portfolio A1 Performance Update: 5/31/08, PortfolioA1, which I updated here on a weekly basis from February 2007 through April 2008, has been tweaked and enhanced to create the VIX and More Focus Aggressive Trader Model Portfolio.

In fact, the subscriber newsletter has four model portfolios that I make available to newsletter subscribers. Since their March 30, 2008 launch, the four (equities only, long only) portfolios have performed as follows:

• Focus Aggressive Trader: +16.93%
  
  
• Focus Growth: +3.25%
  
  
• Focus Foreign Growth: +9.75%
  
  
• Stock of the Week Sequential Portfolio: +64.58%

In addition to the model portfolios, the subscriber newsletter includes a number of regular weekly sections, including a market commentary, asset class outlook, market sentiment update, current investment thesis, and week in review. Features generally focus on subjects such as sector rotation, volatility, put to call ratios, market breadth, volume, and other sentiment-related issues. Some of the May features have included:

• Technology Leadership Is Bullish
• New Picks from the Volatility-Based Sector Rotation Model
• Interpreting the Recent Low VIX
• An Expanded Look at the VIX:VXV Ratio
• Measuring Complacency
• ETF Reversal Swing Trader
• Trading Oil with ETFs
• Different Ways to Cross the 200 Day SMA
• The Role of Speculation in Oil Prices
• Oil, Energy, and Correlations

I continue to be pleased by the positive feedback from subscribers, 25% of whom are located outside of the United States, which has included the following comments:

I really appreciate all your help and the thoughtful views you have of the market…It appears you have a knack for picking the stock of the week! -- PP, USA

You've blogged only rarely on the broader thrust of the newsletter. It comes off as applied VIX, or perhaps punches up the "..and More" part of "VIX and More". -- DK, USA

The newsletter is exactly what I am looking for. -- MD, Germany

I loved your Sunday edition. Congrats on the success of your picks. -- VH, USA

For more information on the subscriber newsletter contents, check out a blog that I have dedicated to the subscriber newsletter: VIX and More Subscriber Newsletter Blog.

If anyone has any additional questions or comments about the subscriber newsletter, please feel free to email me at bill.luby@gmail.com

Portfolio A1 Performance Update: 5/31/08

Since I continue to receive inquiries about Portfolio A1 as well as my new subscriber newsletter model portfolios, I thought I would provide a snapshot of the portfolios at the end of each month.

The chart below shows the equity curve and some summary statistics for Portfolio A1 since the portfolio (which is equities only, long only) was created on February 16, 2007. During the 15 ½ months since inception, Portfolio A1 has posted a cumulative return (exclusive of dividends) of 19.8%, while the benchmark S&P 500 index has declined 3.8%.

The graphic to the right provides some additional performance details for Portfolio A1 vs. the S&P 500 index over a variety of time frames.

For the record, Portfolio A1’s current holdings include: Mosaic (MOS); TBS International (TBSI); PetroQuest (PQ); World Acceptance (WRLD); and Brasil Telecom Participacoes (BRP). Portfolio A1 also shares some common ancestry and has a stock ranking system that is similar to the VIX and More Focus Aggressive Trader model portfolio – one of the four model portfolios that I update transaction by transaction for newsletter subscribers. At some point later this weekend, I will provide some details about the performance of the subscriber newsletter portfolios.

Finally, I would be remiss in not reiterating that Portfolio A1 was created with tools developed by Portfolio123.com and is managed via Portfolio123.com’s tool set. For more information on Portfolio123.com, please refer to an earlier post on the subject, Portfolio123.com: The Engine Behind Portfolio A1. [For the record, I have no affiliation with Portfolio123.com]

Agricultural Commodities vs. Base Metals

I’ll be the first to admit that I am sometimes guilty of oversimplifying the commodities world by lumping all commodities together for the purpose of making broad comparisons between equities and commodities. When I break out a particular commodity, it is usually crude oil or gold.

In fact, the recent action in agricultural commodities and base metals has been at least as interesting as the action in the energy and precious metals baskets. Many of the same factors – supply and demand, inflation, geopolitics, etc. – are at work across the full spectrum of commodities. Sometimes the geopolitics of agricultural commodities and precious metals are on par with that of oil politics. Just ask the Chinese…

The chart below compares the ETFs associated with the PowerShares Deutsche Bank Liquid Commodity Index – Agriculture (DBA) with the comparable ETF for base metals (DBB) over the course of the 17 month life of the ETFs. The chart shows three distinct internal trends within the broad commodity sector: the strong metals performance for the first four months of 2007; the sharp rally in agricultural commodities relative to metals during the remainder of 2007; and the more recent (albeit less dramatic) tilting of the pendulum back in the direction of base metals.

At the moment, both agricultural commodities and base metals are struggling to hold on to gains made over the past six months. There are a myriad of ways in which to invest in commodities over the long-term or to take short-term speculative positions. When thinking about the latter alternative, do not overlook a pairs trading approach.

It’s the Oil, Stupid

When it comes to volatility, there are few catalysts that can spook the market like the prospect of an oil shortage. With today’s announcement that crude oil inventories fell 8.8 million barrels when analysts were expecting a slight increase in inventory levels, the markets reacted sharply, with crude futures immediately spiking almost $4 per barrel to over $133. In spite of today’s jump, crude is still trading below the all-time high of $135.09 and has pulled back toward 130. Still, 135 will be an important resistance level to watch going forward. If 135 holds, volatility should be contained; if it is breached, expect equities to face and volatility to surge with crude prices.

One more thing: tomorrow is the last trading day before the official beginning of the Atlantic hurricane season…

Comparative Volatility Indices

I am a strong believer in simplifying life – and one’s approach to investing – as much as possible. Less is more.

With that thought in mind, I pulled up a six month chart of the five major US volatility indices: VIX, VXO, VXN, RVX, and VXD. The chart, which comes courtesy of BigCharts, shows that over the past six months, the difference between the volatility indices are no more than subtle nuances. Keep in mind that during this period, the financial sector was extremely hard hit. Moreover, financials are overrepresented in the VIX and VXO, underrepresented in the RVX, and absent from the VXN. The sector distinction is all but lost in the charts (except perhaps from mid-February to mid-March) and if there were ever a time for the indices to diverge in a meaningful way, this was it.

The bottom line is that for most market observers, it makes sense to follow only the VIX. Volatility aficionados may also choose to follow the VXN, but after adding a second volatility index to one’s radar, the incremental return on effort and complexity diminishes rapidly.

When there are important divergences between these indices, I will be quick to point these out, but for the most part, expect my comments about the VIX to apply to the entire volatility index family tree as a whole.

Whither COF?

Ever since the onset of the credit crisis, it seemed like only a matter of time before problems in the area of home mortgages and HELOCs inevitably spread to credit cards. Given that Capital One Financial (COF) has dipped heavily into the subprime borrower market, it seems to reason that COF will be a large part of the collateral damage.

So far, COF has been able to keep charge offs at a manageable rate, one that was stable at 6.1% in March and April. This leveling off of the charge-offs in the most recent month prompted Goldman Sachs analyst Brian Foran to offer optimistically, “any sign that credit deterioration in U.S. card could be taking a breather is positive.”

COF’s stock is currently 30% above the January low and has traded in an ascending triangle, as the chart below shows. While the stock is up this morning, it is testing the bottom of the triangle pattern. Ominously, on balance volume shows a significant divergence from the price pattern, with at least three significant distribution days (down on above average volume) over the past four weeks.

While XLF, XBD, C and LEH are all important indicators of the health of the financial sector, keep an eye on COF to see how the credit crisis is affecting subprime credit card holders.

VIX Implied Volatility Surges

This is where things get fun. The VIX is a measure of implied volatility of SPX options, yet the VIX also has its own implied volatility, derived from VIX options, which I am simply going to call VIX IV. Since we are on the verge of a long weekend (for some), just think of the VIX IV as the implied volatility of the implied volatility of the S&P 500 index. If you prefer, call it meta volatility.

The reason I bring up these mental gymnastics is that the implied volatility of VIX options has been increasing dramatically over the course of the past two weeks. Given that there are different methods for calculating an aggregate implied volatility number across a range of strikes, it is not surprising that different sources can arrive at a different aggregate IV value. In the case of the VIX, the three month implied volatility charts from optionsXpress (above right) and iVolatility.com (below) seem to arrive at very similar numbers, with the VIX IV jumping from about 50 to 115 or so over the past two weeks. In the case of the ISE (very bottom), their methodology shows VIX IV hitting a new 52 week high of 230 on yesterday and hovering around 198 today.

I am not sure why there is such a large discrepancy between the ISE and the other two sources – and I will be back to clarify this when I get a good explanation – but the key takeaway is that while implied volatility in the SPX is starting to edge back up slowly, volatility in the VIX is surging. There are several possible explanations for this phenomenon, but in all cases, the surge in VIX IV suggests that options traders are pricing in much higher uncertainty associated with near-term VIX values. One possible translation: traders believe that the probability of a significant spike in the VIX is increasing.

The Big Question for the VIX

There are a lot of important questions about the markets that are being hotly debated as I write this. These include:

• Are we in a recession?
• Will crude oil break 150 soon?
• How long will it be until the housing market finally hits bottom?
• Can the indices take out their 200 day SMAs?
• Why is the VIX still under 20?

OK, so I was kidding about the last one. Judging by the number of visitors this blog gets, there is a fair amount of interest (about five times as much as there was a year ago) in the nanosubject known as the VIX.

Condor Options, a site that is part of my regular reading, wonders if the VIX phenomenon has jumped the shark. Drawing upon the latest from Steven Sears, Don’t Read too Much Into a Rising VIX, my avian friends opine (in Has the VIX Jumped the Shark) that “the VIX has definitely received too much attention of late, and is being asked to perform too many roles - market timer, sentiment indicator, and even trading vehicle.”

The gist of the Condor Options argument comes a little later:

“…it’s getting harder and harder to find a source whose daily market commentary doesn’t feature at least a casual nod to VIX action, and more importantly, those passing references almost always describe it one-dimensionally as ‘the fear index.’”

I was debating whether to weigh in on some of the particulars of the Condor Options article when another prominent blogger who bears more than a passing resemblance to Henry Winkler picked up on the VIX theme and added:

“The VIX is just one tool in the shed, and a very imperfect one. It is an estimate, and as such, there is a boatful of noise in the number any time you look at it. At the end of the day, it tends to confirm something you already knew. Back in January and March the VIX spiked as the market got plowed and peaked on those big down gap days. Guess what, emotions got extreme.”

Adam (of Daily Options Report fame) also offered some good advice to VIX watchers. “Going forward, we should forget about the blips, myself included…[a]nd we should concentrate on looking for divergences.”

Condor Options and Adam certainly make some excellent points. Regarding the larger question of whether or not the VIX has jumped the shark, my answer is that when I started a blog about the VIX with a tongue-in-cheek tagline of “Your One Stop VIX-Centric View of the Universe…” some seventeen months ago, the water skis were already passing over the dorsal fin.

With respect to the ‘fear index’ label, divergence analysis, and several other specific points about the VIX, I will save these subjects for more detailed treatment at a later date.

Gold vs. Oil

Peak Oil or not, crude has had an incredible run as of late. If you have any doubt about how sharp the move has been, check out Tim Knight’s Elliott wave count and chart at The Slope of Hope.

As the chart below shows, gold has had quite a run too (see the area chart), but lately oil has been outperforming gold. One way to interpret this ratio chart is to think of what an ounce of gold would cost if it were priced in barrels of oil. As anyone who has been to Dubai lately can tell you, it is taking less and less oil to buy an equivalent amount of gold these days.

There was a time when a house was considered to be one of the best hedges against inflation. Clearly that is not the case at the moment – at least in the US. Gold has historically been an even better inflationary hedge, but lately oil has outpaced gold in that area. The oil trade is very crowded at the moment and when oil turns down, there will still be many who are seeking alternative hedges against inflation. Don’t be surprised if a lot of that oil money flows into gold and sends the gold to oil ratio back toward historical norms.