Another Winner from Jeff Augen

While I never got around to a formal review, I did give Jeff Augen’s The Volatility Edge in Options Trading: New Technical Strategies for Investing in Unstable Markets a Best New Volatility Book award in the VIX and More 2008 Volatility Awards. I thought that book did an excellent job in providing new insights in how to trade the earnings cycle and the options expiration cycle.

I recently had the chance to read Augen’s latest book, Trading Options at Expiration: Strategies and Models for Winning the Endgame and once again had a very favorable reaction. This time around Augen focuses almost entirely on the last two days of the options expiration cycle and offers up some interesting ideas and trading strategies to take advantage of anomalies in time decay and implied volatility.

Augen’s new book does not have the heft of the original, but the focus is one of the book’s strengths.

If you are like me, you probably find the last two days of the options expiration cycle to be among the most difficult periods to trade. After reading Trading Options at Expiration, I guarantee (and how many guarantees are there in the investing world?) that you will look at the end of options expiration week differently and see more opportunities than pitfalls.

With three days until the end of the current options expiration cycle, now is as good a time as any to start evaluating some new strategic approaches.

VIX Term Structure and VIX Forecasts

Last Friday, Jeff Kearns of Bloomberg had a story with the title VIX Futures Show Traders Betting Stock Rally to End that triggered a large number of emails from readers. The quote from the article that seemed to generate the most amount of interest was, “Investors surveyed by Macro Risk Advisors expect the VIX to jump to as much as 51.70 by year end.” In fact, the 51.70 data point was the average high print expected by respondents who were surveyed in April, when the VIX ranged from 33 to 46. That data point and the balance of the results from the Volatility Forecast Survey make for some interesting reading. Even more interesting, however, is the April 2008 Volatility Forecast Survey, in which respondents expected average realized volatility of 20.9% for the balance of 2008, with an average VIX high print of 34.4. One brave soul went out on a limb and predicted that the VIX would spike to a new all-time high of 50.

I guess nobody knew what a category 5 VIX hurricane looked like, so extrapolating from historical data, they were having trouble imagining what was coming.

Getting back to the 2009 survey data, while I find it intriguing, I would put a lot less credence into survey data that is several weeks old than real-time market data. One can construct a VIX term structure graph from VIX futures or SPX options. My preference is for the latter approach, which yields a graph like the one below. Note that the slope of the VIX term structure is almost flat. Certainly the 0.11 differential between the front month and 2 ½ years out is in stark contrast to the 33.93 point differential from November 20, 2008, when the front month VIX was 81.07. Essentially, the consensus opinion is that current volatility measures are about where they should be, with no significant changes anticipated going forward.

Finally, while survey respondents likely had the best of intentions when constructing their volatility forecasts last month, there is nothing like current market data to get a sense of how investors are backing up their beliefs with large dollar value positions in the options market.

[source: CBOE, VIXandMore]

Chart of the Week: Breaking Out Recent Commodities Moves

This week’s chart of the week looks at commodities, where base metals (blue line) and energy (red line) began to bottom just after the middle of February, about 2 ½ weeks before stocks put in a bottom. Interestingly, agriculture (green line) bottomed on March 2^nd, just before stocks found their bottom. Precious metals, which marches to the beat of a very different drummer during periods of economic stress, bottomed back on November 12^th and made its most recent high on February 23^rd, just as base metals and energy began to rally.

The chart below captures the action in four commodity sub-sector ETFs since February 17^th. The chart shows the base metals ETF (DBB) to be the strongest performer during this period. While DBB has faltered in the past few days, energy (DBE) has surged. Agriculture (DBA) has recently joined the bull party and with concerns about rising interest rates heating up, even precious metals (DBP) have started to rally as well.

It would not surprise me if 3-4 of these commodity sub-sector ETFs outperform the S&P 500 index for the rest of 2009. At the very least, they could provide some important portfolio diversification and a potential hedge against inflation.

[source: StockCharts]

Disclosure: Long DBB at time of writing.

How Low Can the VIX Go?

With the bank stress tests results and the April employment report out of the way, volatility is cratering and the VIX is down to 31.45 as I type this.

So how low will the VIX go?

A little more than two weeks ago, in The New VIX Macro Cycle Picture, I suggested that for the current bull leg, 30 was a good guess for a VIX floor. That prediction was part art and part science, to be sure, but there were quite a few technical factors that went into the calculation.

You don’t need a fancy model, however, to make a ballpark prediction for the VIX. I will share a quick and dirty back of the envelope calculation. Since the VIX averages approximately 1.3x the historical volatility of the SPX, one can use the 10, 20 and 100 day historical volatility data to come up with three estimates of the VIX. Generally, I take the lowest one as a floor and average the two readings that are closest together to come up with an expectation of an appropriate current level of the VIX.

With the 10 day historical volatility at 24.10 yesterday, a 1.3x multiplier yields a 31.33 VIX. For the 20 day HV, the numbers are 29.95 and 38.93. The 100 day HV, which includes SPX data going back to December 12^th, is 37.52, with a 1.3x multiplier yielding 48.77.

So…the back of the envelope calculations suggest a VIX floor of 31.33 (today’s low is 31.39) and an appropriate current VIX of 35.13.

Remember that these are guidelines at best and assume that the next 30 days will bear a reasonable resemblance to recent history. Still, they support the contention that we are nearing a VIX floor.

For the record, the lowest 10, 20 or 100 day historical volatility level recorded in the past six months was a 10 day HV of 20.38, which translates into a VIX of 26.69. For anyone looking for the lowest possible extreme in the VIX in the near future, 26 would be a good bet. This is also consistent with my earlier prediction that the VIX is not likely to breach a floor of 25-27.

The Banks vs. Technology

I was going to put up a post about the recent negative divergence in technology, particularly the large cap technology companies that dominate the NASDAQ-100 (NDX), but I noticed that Cam Hui at Humble Student of the Markets already beat me to the punch yesterday morning in an excellent Weak Leadership Imperils Market Advance.

Interestingly, since Cam’s post, the divergence between financials and technology has accelerated as the banks have continued to rise in advance of and in response to the release of the stress test results, while large cap technology has been trending down since Monday.

So far the financials (XLF) have done a better job of leading the market up than technology stocks (XLK) have done of inspiring the bears. Until these two sectors start to move in unison, though, I suspect we will have a stalemate.

[source: BigCharts]

VXX Calculations, VIX Futures and Time Decay

As I type this, the VIX is up about 6.5% for the day and VXX is only up about 2.0%.

While it looks like today is a good day to be long volatility, getting 4/13 of the move in the VIX with a VIX ETN does not look like an efficient way to play the volatility trade. In fact, I have discussed the issue of what I call the VXX juice factor on a number of occasions and have concluded that on average, anyone owning VXX should not expect to capture more than 50% of the move in the VIX, at least based on data since the January 30^th launch of VXX. Going forward, however, 40% might be a more realistic target.

A reader asked about the extent to which VXX returns may be adversely impacted by time decay, rolling and other issues.

When it comes to VXX price erosion, there are two primary factors to consider. The first is the mean-reverting tendency of the VIX and VIX futures. The second factor is the daily rebalancing of the two VIX futures that are utilized to calculate the value of VXX.

The VXX calculation is derived from the two nearest months of VIX futures. At the moment, this means the May futures and the June futures. For the sake of simplicity, I will refer to these as the front month and second month futures. I’ll explain the calculation with an example.

VIX options expire on Wednesday, May 20^th this month (see 2009 expiration calendar), which means that at the close of business on the day before expiration, May 19^th, VXX will hold exclusively the June VIX futures (VX-M9). As each calendar day passes, VXX will sell 1/23 (there are 23 trading days in the current VIX options expiration cycle) of the June VIX futures position and buy an identical amount of the July VIX futures, so that the percentage holdings of the front month and second month futures always create a synthetic blend of a basket of VIX futures with a constant maturity of 30 days. [Note that this is different from the calculations of the cash VIX, where the front month and second month options roll forward one month 8 days before VIX options expiration.]

As long as the near month and second month futures are similar in price, the daily rebalancing has little effect on the price of VXX. When the term structure has a steep slope and there is a substantial difference in price between the front month and the second month (as was the case with SPX options on 11/20/08), the daily rebalancing can generate its own profit and loss. As the graphic below shows, there was a 0.75 difference between the May and June futures settlement prices yesterday. Calculating 1/23 * 0.75, yesterday’s daily rebalancing probably resulted in a 0.03 change in price.

In terms of pricing implications, when VIX futures are in contango (upward sloping over time, second month more expensive than front month), there will be a daily loss of value due to rebalancing. On the other hand, when VIX futures are in backwardation (downward sloping over time), the daily rebalancing process will generate a gain.

Following the launch of VXX on January 30^th, VIX futures were consistently in backwardation until the beginning of April, at which point the term structure flattened out. At present, there is some slight contango that could adversely impact VXX prices going forward. Technically, this rebalancing is called "roll yield" and when the roll yield becomes negative, VXX prices will suffer daily losses as a result.

For more on this subject I recommend Standard & Poor’s white paper on VXX returns: Directional Exposure to Volatility Via Listed Futures

For more details on VXX, iPath has two documents worth checking out:

• Prospectus
• Information Sheet

[graphics: FutureSource]

Disclosure: Long VIX and VXX at time of writing.

Sequencing Stocks, Jobs and GDP in a Rebound

Sometimes my ability to overlook the obvious amazes me – and I’m not talking just about my trading.

I should have known I was overlooking something important when several of the recent Abnormal Returns (almost) daily links referenced a blog by the name of Sentiment’s Edge. With Jason Goepfert at SentimenTrader and Brent Leonard at Market Sentiment all over that space, I wondered to myself what need was there for a new entrant in the market sentiment space. As it turns out, Jason Goepfert, who runs the subscription-only SentimenTrader, started a free blog back in January: Sentiment’s Edge. Perhaps it took a sub-35 VIX for me to get my perceptual edge back.

In any event, as a subscriber to SentimenTrader (and I very rarely subscribe to anything), I am delighted to see that Jason is putting more of his thinking out in the public domain. As a rule, VIX and More generally focuses on free content and does not comment on content that is available only via a paid subscription.

If you have never been to Sentiment’s Edge, today is a good day to get a sense of the type of analysis you can expect to find here. In The Economy Vs. the Market, Jason draws upon work from The Pragmatic Capitalist to analyze turning points in stocks, joblessness and GDP. His conclusion? Prior to the dot com crash earlier in the decade, the typical pattern was for stocks to lead, jobless claims to follow and GDP to turn last. Follow the click and the graphics tell the story.

Clearly stocks have made a turn, if not the turn. The trend in initial jobless claims are a little murkier, but if today’s ADP employment numbers are confirmed by tomorrows jobless claims data and perhaps Friday’s employment report, then the old pattern may be returning, with only GDP left to reverse.

Frankly, I probably won’t start to be convinced about an economic turnaround until I see more than a month’s worth of progress on the initial jobless claims data, as well as some evidence that there are improvements in continuing jobless claims as well.

Bullish on VXX

All the preannouncements have taken most of the uncertainty out of the unveiling of the bank stress test results and not surprisingly, volatility has collapsed. With the VIX at 32.53 and VXX last trading at 85.19, this looks like a good time to get long VXX and/or VIX options.

[source: BigCharts]

Disclosure: Long VIX and VXX at time of writing.

SPX 915 as a Top?

I have a strong feeling that the 915 level on the SPX hit in the first half hour of trading today will hold up for awhile. Of course, anything is possible with the bank stress tests and the employment report on deck, but I am betting on 915 holding, especially if the NDX (NASDAQ-100 continues to be relatively weak)

Technical Analysis, Condor Options and the Lessons of 2007-09

If you do not have Condor Options on your reading list, then you are missing out on what I consider to be perhaps the most deftly written and intelligently reasoned investment blog out there. To top it off, the topics are timely, there is a liberal sprinkling of wry humor, and if you have a dictionary handy, you can usually increase your vocabulary too.

Don’t take my word for it though. Check out today’s Technical Analysis Fails to Give You a Pony and see for yourself. In what may be my favorite post of the year so far, Condor Options, provides a sharp counterpoint to Michael Tsang and Eric Martin, whose Stock Charts Fail Forecast Test in Complete S&P Miss argues that technical analysis strategies failed investors from the October 2007 peak to the March 2009 decline. The Condor critique includes a discussion of indicator selection and time frame selection. It also notes that each of eight indicators did beat S&P 500 during evaluation period.

Well done, my avian friends.

But before this starts to sound like an infomercial, I want to hop onto a tangential thought that I have been ruminating about for the last few months: what lessons should we take away from the 2007-09 bear market?

Now I know the issue of learning lessons from the recent bear market is a big subject and I have no intention of taking more than a first pass at it this time around, but since I haven’t seen it discussed at any length elsewhere, today seems like a good day to dive in.

First, consider the possibility that there are no lessons to learn from the last year or so. While this may sound heretical at first blush, it is certainly possible that the confluence of events that put the financial system and the markets in peril over the course of the last year will not be repeated during the course of my trading lifetime and perhaps yours as well. This may be a little naïve, but consider that it was 21 years between VIX spikes over 80 and more than 70 years since we have seen a bear market as aggressive as the recent one.

Another way to think about the recent bear market is to consider an analogy to an N-year flood. In preparing for an N-year flood, it may be desirable to build a dam and levee system that is capable of containing an N-year flood. On the other hand, it may make more sense to construct a system that is designed to withstand only a fraction of an N-year flood and to focus more resources on an optimal evacuation plan and communication system.

Switching metaphors, think of the big wave surfer who is comfortable riding 20 and 30 foot winter swells and might consider hopping on a 50 footer at Maverick’s if he or she thought it might win the competition. At some point, however, the waves become too big and dangerous to try to ride. At some point, we are all better off being spectators.

By the same token, it is certainly acceptable to have a trading system that reverts to all cash when certain events hit a global exit trigger. These might includes triggers such as a 20% peak to trough drawdown in the SPX, a close of greater than 50 in the VIX, the loss of 25% or more in one’s account equity, etc.

I do think there are important lessons to learn from the recent bear market, but I think the first thing most investors should consider is that they only need to play the game when the odds are in their favor.

I will have a lot more on this subject in future posts.

SPX Reclaims 900 Level

The S&P 500 index has not traded above the 900 level since the beginning of January, but just edged above that number a moment ago.

In spite of all the recent bullishness in stocks, my evaluation of the risk/reward ratio of the markets has me positioned with a bearish bias at the the moment.

Percentage of NYSE Stocks Above 200 Day SMA

While it is similar in construction to yesterday’s chart of the week (the percentage of NYSE stocks above their 50 day simple moving averages), a chart of the percentage of NYSE stocks above their 200 day moving averages looks much different from the 50 day version and is generally subject to a much different interpretation.

The chart below is a weekly chart of the percentage of stocks trading above their 200 day simple moving averages since 2002. As the graphic demonstrates, the 200 day moving average does an admirable job of capturing the strength of the long-term trend. During the 2003-2007 bull market, for instance, pullbacks to 50 percent represented excellent buying opportunities. Furthermore, when the percentage of NYSE stocks above their 200 day SMA failed to surpass the 60 percent level in October 2007, this should have been taken as a sign that market breadth was weak and the bull market was in danger.

As 200 days encompasses approximately 9 ½ months of trading, large swings in the 200 day percentage data have a tendency to significantly lag the market. For this reason, interpreting the chart below should focus on swings of at least 30 percent that move the aggregate percentages above the 60 level or below the 40 level. Applying this interpretation to the chart below, the current bull move should be considered a bull market when the percentage of NYSE stocks above their 200 day SMA exceeds 60.

[source: StockCharts]

Chart of the Week: Percentage of NYSE Stocks Above 50 Day SMA

This week’s chart of the week is a little different than some of its predecessors. The chart below is a weekly chart that tracks the percentage of stocks currently trading above their 50 day simple moving averages. The data are available going back to 2002 and show the only other time that the percentage climbed above 90 was in 2003, as the markets were rallying off of the 2002-03 bottoms.

For the most part, the percentage of stocks above their 50 day SMA tends to top out in the 75-85 range and then correct, with corrections that stay above 20-25 representing excellent buying opportunities. On the other hand, corrections that dip below the 20-25 range run a much higher risk of turning into longer-term bear trends.

At a current level of 90.03% above the 50 day SMA, the two month rally has to be considered extended, but not necessarily without any additional headroom. Given the magnitude of the 2007-09 drop, such bullish extremes on a subsequent bounce should not come as a surprise, but they should cause the bulls to be a little more cautious.

[source: StockCharts]

Short-Covering Rally Data Points

On March 9^th I put together a portfolio of ten highly liquid stocks and ETFs that had extreme short interest positions. I posted about this portfolio the next morning in Short-Covering Driving Today’s Gains.

I thought this would be a good time to share the performance of these heavily shorted stocks and ETFs during the course of the past 7 ½ weeks. I have the graphics below from Finviz.com to show how the portfolio has performed. As a bond ETF, TLT probably should not be in the group, but since I included it in the original portfolio, I’m leaving it in here for now. For what it’s worth, removing TLT from the portfolio pushes the total return up to 116.60%. Clearly, a large part of the recent gains have come from short covering the likes of Deutsche Bank (DB), MGM Mirage (MGM), and shopping center REITs Macerich (MAC) and CBL & Associates (CBL).

[source: FINVIZ.com]

The Looming Commercial Real Estate Crisis

I was going to set aside the subject of commercial real estate for now, but it just so happens that Kevin Hall at McClatchy has penned a superb overview of the potential problems in this area in Next Economic Crisis Looms: Commercial Real Estate Defaults. (Hat tip, Deal Junkie)

Rather than providing some snippets from the McClatchy piece, I recommend that readers click through to read the entire article.