Graphical Comparison of Performance of PutWrite and BuyWrite Indices

I was pleased to see the strong response generated by Friday’s The Often Overlooked Put Writing Strategy, particularly in some of the comments at Seeking Alpha, where the post was republished. A number of questions came up regarding the reasons why two strategies that are synthetically equivalent (i.e. share the same profit and loss graph), would have different performance characteristics. I cited the main reason for the performance delta as the skew that results from a tendency to price puts higher than calls, particularly during times of extreme market stress, when demand for puts often exceeds the demand for calls.

I am not sure that I can prove beyond a reasonable doubt the skew hypothesis in this space, but I did assemble two performance graphs that might help to inform any further discussion. Using the CBOE PutWrite Index (PUT) and the CBOE BuyWrite Index (BXM) as my source data, I have plotted the two indices from their 1988 inception (above) and from 2002 (below), when the indices begin to substantially diverge.

From the two graphs, I find it interesting that the put-write strategy begins to generate separation from the buy-write strategy during the 2002-07 bull market. As volatility increases during 2007, the put-write strategy continues to widen the gap, with the recent bear market having very little impact on the performance differential between the strategies.

Those who have any thoughts on the reasons behind the performance differential during different market cycles, please feel free to chime in.

[source: CBOE, VIX and More]

Chart of the Week: Volatility Drifts Lower

While stocks gave back some gains this week and any sense of inevitability was stricken from the consciousness of the bulls, volatility only grudgingly began to reappear on the charts.

In fact, if you look at the chart of the week below, you see more concern about future volatility in the form of the VIX than there are indications of rising current volatility, as reflected in the average true range (ATR) of the S&P 500 index. I elected to use the 21 day setting for the ATR, as it is based on trading days and approximates the 30 calendar day time horizon used by the VIX. For the record, shortening the ATR window to 10 days shows the same pattern of declining volatility. The SPX historical volatility picture is similarly calm, with 20 day historical volatility hovering around 31 at the moment.

Even with the markets selling off this week, volatility remains relatively low, at least as measured by post-Lehman standards.

[source: StockCharts]

The Often Overlooked Put Writing Strategy

Shame on me for going a year and a half without mentioning the CBOE S&P 500 PutWrite Index (PUT), a recipient of the Most Innovative Benchmark Index award at last year’s Super Bowl of Indexing Conference.

Given all the market volatility for the past three months or so, I suspect that a put writing strategy is probably not top of mind for most investors at the moment. In fact, a put write strategy like one tracked by the PutWrite Index will generally outperform the S&P 500 index in a down trending market and significantly outperform the S&P 500 index in a sideways market. Much like a covered call strategy, however, a put write approach will not match the gains of the underlying index in a strong bull market rally.

The CBOE describes the PutWrite Index methodology as follows:

“The PUT strategy is designed to sell a sequence of one-month, at-the-money, S&P 500 Index puts and invest cash at one- and three-month Treasury Bill rates. The number of puts sold varies from month to month, but is limited so that the amount held in Treasury Bills can finance the maximum possible loss from final settlement of the SPX puts.”

Additional information about the PutWrite Index is available at the CBOE PutWrite Index splash page.
I mention put write strategies for four reasons:

1. If we continue in a non-trending market, as I expect we will, this is an excellent investment approach
2. Ennis Knupp just published a superb analysis of the PutWrite Index: Evaluating the Performance Characteristics of the CBOE PutWrite Index
3. Put write strategies have historically outperformed the more widely utilized buy write strategies
4. Properly implemented, a put write strategy is not as risky as most investors expect
   

At a minimum, readers should check out the Ennis Knupp paper and get a better sense of the essence of put write strategies. Those who expect the markets to do anything other than rally significantly might also want to start implementing that strategy on their own.

Note that while there are currently no ETFs that utilize a put write strategy, it is a volatility strategy that is practiced by hedge funds.

MarketSci Looks at the VIX 5% Rule

MarketSci is a blog that somehow manages to ponder the same sort of issues that I like to chew on. Fortunately, MarketSci does more than ponder. In fact, much like the approach favored by Quantifiable Edges, MarketSci seems to aspire to being the mythbusters of the investment world.

This week MarketSci has particularly interesting series of items on its plate: the Trading Markets 10 Trading Rules. One by one, MarketSci is taking a data-driven approach to determining the usefulness of each of the Trading Markets rules.

In today’s installment, Testing TM Rule #5: the VIX 5% Rule, MarketSci examines the popular TradingMarkets 5% rule that I discussed in 2007 in a post with the unlikely title of The TradingMarkets 5% VIX Rule. In short, MarketSci comes down on the side of the usefulness of the 5% rule as a defensive measure. The full analysis is worth clicking through for, as are the other installments in the analysis of the ten trading rules, most of which are consistent with my own thinking and several of which should probably be part of every trader’s arsenal.

Two Year Blogiversary

With all the excitement of the trading day, the VIX back up to 42.55 as I type this, and my share of technical issues (MyBlogLog, if would be nice if you could go back to tracking more than 20% of my traffic), I forgot that today is the two year anniversary of VIX and More.

Thanks to Adam Warner, Jim Kingsland, Barry Ritholtz and a host of others who offered their early encouragement back when I could count my visitors on my hands and toes.

For those who may be interested, the first post, VIX and More: An Introduction, still has some nuggets that are relevant for today’s market. My favorite post from that first month, however, is undoubtedly What My Dog Can Tell Us About Volatility.

Thanks to all who have made contributions of one kind or another to this effort over the course of the past two years.

Satyam, Fraud, and the India VIX

Today’s announcement that Satyam (SAY), the Indian outsourcing giant, has been engaged in a massive accounting fraud over the course of several years sent Satyam down 78% in local trading and dragged the Bombay Sensex down 7.3%.

All things considered, I was once again surprised by the relatively small spike in the India VIX, which jumped 14.5% to close at 44.36.

In the chart below I have plotted the course of the India VIX since November 2007 (the index launched in April 2008, but historical data has been reconstructed extending back another six months.) I find it interesting that the scale of the India VIX is not that much different than that of its U.S. counterpart. I also find it interesting that concerns about the global financial crisis in October 2008 was responsible for the peak in the volatility index, while the Mumbai terrorist attacks the following month barely register as a blip on the chart.

It remains to be seen what sort of long-term fallout the Satyam fraud will have on Indian equities, but so far the reaction has to be considered a relatively muted one.

Keep in mind that after many failed attempts at a bottom in 2001 and 2002, the NASDAQ did not put in a bottom until just after the WorldCom bankruptcy filing.

[source: National Stock Exchange of India, VIX and More]

On Volatility, Probabilities and Distributions

When I was in the process of publishing the winners of the 2008 Volatility Awards last week, I paused before finalizing Don Fishback’s Market Update as the recipient of the award for Best New Blog with a Volatility Focus. While there are many excellent blogs out there, my hesitation had nothing to do with the quality of Don’s site, which you should judge for yourself. Instead I wondered what would happen if hundreds of curious readers clicked over to the site and Don just happened to be taking a couple of weeks off for the holidays.

Well…Don is back and has a post up that is the early leader in the volatility post of the year category (should I decide to invent such a beast at some point.) Starting with the not-so-pity title of Probability, VIX, Bad Math, and Reporters Who Don’t Know the Difference: Measure, Don’t Model, Don Addresses some of the mathematical shortcomings of the Kearns and Tsang article, VIX Fails to Forecast S&P 500 Drop, Loses Followers and argues from the specific to the general case. For dessert, Don Serves up a nifty tool to help readers visualize the various probabilities and distributions associated with the VIX and the SPX.

Assuming the VIX does not spike back up to the 80s again, I will use this space to talk a lot more about probabilities and distributions in 2009 – and their application to the study of volatility.

Market Rewind on Risk

Since Joe Nocera, Michael Lewis and David Einhorn all had a chance to talk about risk in yesterday’s Required Reading segment, I thought it was timely of Jeff Pietsch at Market Rewind to pick this morning to offer up some of his thoughts on the subject of risk.

In ETF Risk in Review, Pietsch draws on data from his ETF Rewind tool to tackle the subject of risk-adjusted performance and ranks the 2008 performance of various ETFs within their grouping according to a Sortino Ratio (similar to the more familiar Sharpe Ratio, but the Sortino Ratio not penalize performance for upside volatility.) Not surprisingly, consumer staples (XLP) and health care (XLV) turn in the some of the best risk-adjusted performance numbers for 2008, while financials (XLF), emerging markets (EEM) and real estate (IYR) are notable laggards.

One key take away from the analysis is the value of thinking of ETFs in terms of miniature portfolios whose performance can be evaluated on a risk-adjusted basis. We witnessed history in 2008 and as painful as some of that history may have been to live through, hopefully we all enter 2009 with the benefit of a healthier and more sophisticated perspective on volatility and risk.

Required Reading: Nocera and Lewis/Einhorn in New York Times

In the event anyone missed them, I want to make sure I offer up a link to two excellent thought pieces from Sunday's New York Times. In no particular order:

1. Joe Nocera’s superb Risk Management, an examination of Value at Risk (VaR) in Sunday’s New York Times Magazine. (Joe also blogs about a wide variety of business topics for the New York Times at Executive Suite.)
   
   
2. Michael Lewis and David Einhorn's The End of the Financial World as We Know It
   

Direxion Triple ETFs Add New Horses to Stable

While skeptics abound about the usefulness of triple ETFs for the long-term investor, I have been saying since early on that the Direxion triple ETFs would revolutionize day trading.

Now that their novelty has worn thin and traders have had an opportunity to experiment with various approaches to trading triple ETFs, these vehicles have become an integral part of the day trading scene, particularly on trend days.

Looking to capitalize on the appeal of these nuclear-tipped trading weapons, Direxion added six new triple ETFs last month. While interest in the new round of ETFs has so far been limited, I predict at least one of the triple ETF pairs has a bright future. My candidates for stardom are the pair of emerging markets ETFs: the 3x bull (EDC) and the -3x bear (EDZ). The reason is simply a lack of competition. At the moment, competition comes in the form of EEV the -2x UltraShort MSCI Emerging Markets ETF from ProShares. While EEV is a popular double inverse ETF, it lacks a companion +2x version for those who want a leveraged bullish play on emerging markets without having to short EEV.

It is harder to see the other new ETF pairs attracting the same attention that the emerging markets are likely to receive. Technology is a favorite investment theme and a source of considerable volatility, but the current ROM (2x) and REW (-2x) have always been second tier ETFs in terms of popularity, lagging well behind QLD and QID, the popular NASDAQ-100 ETFs. The new Direxion entries, TYH (3x) and TYP (-3x) clearly have their work cut out for them.

Last but not least are a pair of ETFs based on the MSCI EAFE index of developed markets and the popular EFA ETF that tracks this index of European, Australasian and Far East companies. The 3x bull (DZK) and the -3x bear (DPK) have a lot of appeal to me as a means by which to speculate or hedge in non-U.S. companies, but whether these funds will receive the same kind of attention as EFA remains to be seen.

For the record, Direxion has outlined their intention to expand the stable of triple ETFs to 32 in their current prospectus. The ETFs currently in the pipeline have a strong international (China, India, Latin America, BRIC) and sector (clean energy, real estate, homebuilders) flavor. The graphic below shows the triple ETFs currently available, with the recent additions circled in red.

These ETFs are not for the faint of heart and anyone who considers trading these might want to read my initial post on the subject to get a sense of some of the risks involved.

[source: Direxion]

The Year in Global Volatility (2008)

In November I launched the VIX and More Global Volatility Index, which is a weighted average of the implied volatility in options for equities in the 15 largest global economies. I will have more to say about the Global Volatility Index in 2009, but want to use this occasion to highlight the index as a means of tracking the rise of volatility in response to major volatility events during the course of the past year. In addition to the Global Volatility Index (shown in red), the chart below captures the Dow Jones World Stock Index (blue), as well as the signing of the TARP legislation (black) and the tickers (dark red) for some of the major financial companies that failed and/or were rescued by the U.S. government.

[source: VIX and More]

Subscriber Newsletter Now Available on Free Trial Basis

I do my best to keep subscriber newsletter information to a minimum on the blog, but I want to make sure readers are aware that I have made a number of enhancements to the subscriber newsletter. The most important change from a content perspective, is that instead of publishing two very different editions on Wednesday and Sunday, I am now combining all the content into one weekly issue, with new content.

Starting with today’s the newsletter, the Market Recap and Commentary section is being expanded into a more comprehensive The Week in Review and separate Market Commentary section. There will be an increased emphasis on a global perspective, macroeconomic issues and fundamental analysis.

Another new section, Volatility Update, tracks and analyze changes in the VIX, the VIX and More Global Volatility Index, the VXV, and a number of related indicators, such as moving averages in the VIX, historical volatility in the SPX, the VIX:VXV ratio, etc.

The new VIX and More Subscriber Newsletter will be published on Sunday evenings going forward, with the following ‘permanent’ sections:

1. The Week in Review
2. Market Commentary
3. The Week Ahead: What to Look For
4. Market Sentiment (using a proprietary Aggregate Market Sentiment Indicator)
5. Volatility Update
6. Asset Class Outlook (short, intermediate, and long-term outlook for ten asset classes)
7. Weekly Feature(s)
8. Current Investment Thesis
9. VIX and More Focus Model Portfolios
10. Stock of the Week

As the newsletter and the economy are undergoing some dramatic changes, I am now making the newsletter available on a free trial basis. In order to receive a free trial, just click on the “Monthly Subscription: Subscribe” button in the upper right hand corner of the subscriber newsletter and follow the instructions. The free trial lasts for 14 days. Readers who elect not to cancel after the 14 day trial period will be billed at a rate of $30 per month.

Also, as a gesture of appreciation to former subscribers, I will add one free month to any subscriber who chooses to re-subscribe.

In response to reader requests, I am also creating a detailed glossary to provide background on terms, abbreviations, acronyms and tickers I frequently refer to in the newsletter.

Thanks to everyone for all their suggestions and encouragement!

Chart of the Week: ISM Plummets

The stock market may have shaken off the December ISM’s 32.4 number, but investors should keep in mind that in the 61 year history of the ISM index, only three previous recessions (1949, 1974-75 and 1980) have seen lower ISM numbers. Even more concerning than the headline manufacturing index number was the report that new orders are now lower than they have been at any time in the 60 year history of the data.

The chart of the week below captures in ISM and the SPX from 1950. In addition to the obvious cliff dive that began in September, I find it interesting that the manufacturing index has been slowly trending down since hitting a high in May 2004.

As an aside, in 2009 I intend to devote more space on the blog to macroeconomic issues (particularly housing, manufacturing and consumer spending), as well global events that shape the geopolitical and economic landscape.

[source: Institute for Supply Management, VIX and More]

Schaeffer and Connors: Two Veteran Perspectives on the VIX

While I wait to see if the VIX might find a new floor in the 30-35 range, I notice that two veteran VIX aficionados, Bernie Schaeffer and Larry Connors, are talking about their current views on the VIX.

Starting with Schaeffer, in Examining the Technicals of the CBOE Market Volatility Index (VIX), the veteran options strategist outlines several of the factors that are influencing his recent thinking on the VIX. Republished from a mid-December subscriber note, Schaeffer’s thinking includes:

• Possible support at the ‘half high’ level of the VIX (50% of the November peak of 89.53)
• The importance of round numbers (a VIX of 50)
• Long-term moving averages (40 week and 80 week)
• Sector correlation (especially commodities vs. financials)
• VIX relative to SPX historical volatility (20 day HV)

David Penn, Editor in Chief at Connors’ TradingMarkets.com, weighed in earlier in the week with In Defense of the VIX, a response to a Bloomberg article by Jeff Kearns and Michael Tsang. Penn favors a relative VIX to an absolute VIX and cites the familiar Connors 5% rule, in which investors should be long the market when the VIX is 5% or more above its 10 day simple moving average and short when the VIX is 5% or more below the 10 day SMA. For those who are interested in learning more about the Connors approach, Short-Term Trading Strategies that Work has some interesting ideas and is a worthy successor to How Markets Really Work: A Quantitative Guide to Stock Market Behavior.

2008 Volatility Awards

I thought I’d spare everyone a silly sounding name like “the VIXies,” so without further ado, here are the highly subjective and not-otherwise-nicknamed VIX and More volatility awards for 2008:

• Best New Volatility Index: India VIX
  
  
• Best New Volatility Product: VIX Binary Options
  
  
• Best New Free Volatility Tool: International Securities Exchange’s Quotes/Volatility Chart and Information
  
  
• Best Previously Ignored Volatility Indicator: TED Spread
  
  
• Best New Blog with a Volatility Focus: Don Fishhback’s Market Update
  
  
• Best New Volatility Webcast: optionsMonster’s Volatility Sonar report
  
  
• Top Volatility Event: Lehman Brothers Failure
  
  
• Best New Volatility Book: The Volatility Edge in Options Trading: New Technical Strategies for Investing in Unstable Markets – Jeff Augen
  
  
• Best Volatility Trade of the Year: SPX Options Carpet Bomb on October VIX Expiration (124% and $180+ million in four trading days)

I’m sure I overlooked some other obvious awards. Feel free to add to this list in the comments section.