How to Trade the VIX

Based upon the search terms that are landing visitors on the blog this morning, it seems as if many readers are interested in how to trade the VIX. This question really boils down to two separate issues: strategies and trading vehicles.

Since I have talked about strategies repeatedly in this space in the past, I thought I would offer a quick summary of trading vehicles today.

First off, it is not possible to trade the VIX directly. Formally known as the CBOE Volatility Index, the VIX calculates market expectations of 30 day implied volatility for S&P 500 index options. The VIX (sometimes referred to as the cash or spot VIX) is a statistic that the CBOE calculates and disseminates every 15 seconds during the trading day. While widely disseminated, this statistic is not available for purchase.

Fortunately, there are a number of VIX derivatives that allow traders to take positions on the VIX without owning the underlying. In no particular order, they are:

1. VIX options – these include standard options as well as VIX binary options
   
   
2. VIX futures – standard VIX futures contracts have a contract size of 1000 times the VIX; the recently added mini-VIX futures have a contract size of 100 times the VIX
   
   
3. VIX ETNs – currently consists of two exchange traded notes: the iPath S&P 500 VIX Short-Term Futures ETN (VXX) and the iPath S&P 500 VIX Mid-Term Futures ETN (VXZ). The former targets one month VIX futures and the latter targets five month VIX futures.

In addition to VIX products, one can always trade options on the SPX (or SPY). A long VIX position is very similar to a long SPX straddle (or strangle); a short VIX position is very similar to a short SPX straddle (or strangle.)

For some additional reading on these subjects, readers are encouraged to check out:

• Ten Things Everyone Should Know About the VIX
• Overview of U.S. Volatility Indices
• Lost in Translation: VXX and VXZ
• VIX Futures Starter Kit
  

Chart of the Week: China Through the Eyes of FXI

One of the biggest stories of 2009 is turning out to be the rapid rebound in the China, both for the economy and for Chinese stocks.

Second quarter GDP was up 15% quarter-over-quarter in China and industrial production is up 10.8% year over year through July. A number of other statistics also show strong growth returning to China following the enactment of recent stimulus measures. Additionally, when pressed for areas of current and future revenue growth in their recent earnings conference calls, American companies were quick to point to the strong rebound in China as one of the few or sometimes the only area of growth.

For these reasons, I have made FXI, the iShares FTSE/Xinhua China 25 Index, the subject of this week’s chart of the week. The chart below is a weekly chart of FXI going back to April 2005 and shows the dramatic gains of 2006 and 2007, the subsequent crash from October 2007 to October 2008, and the 129% bounce from the October bottom to the August 3^rd top. In the two weeks since topping, FXI has fallen about 6.4%.

In the last year, Chinese stocks bottomed before their U.S. counterparts, had a much more significant bounce off of that bottom, and also topped before U.S. stocks did. Are Chinese stocks pointing to a correction? Can U.S. stocks continue to make new highs without new highs from Chinese equities? Will technical resistance at the 100 week moving average become a significant hurdle for FXI? I expect we will have much better answers to these questions before Labor Day rolls around.

For two excellent resources on Chinese markets, I recommend:

• China Financial Markets (Michael Pettis)
• China Analyst

[source: StockCharts]

Pairs Trading with ROB

While I have never written down any sort of mission statement or goals for VIX and More, my aim here has always been to bring fresh ideas, new subject matter and original graphics to an investment landscape that I find all too often overrun by the same warmed over sound bites and clichés.

Ideally, I would like to give readers a steady diet of ideas and concepts they can ruminate about and use to incorporate new thinking into their trading.

I have never been keen on trading blogs, but there are times when I should probably make a better effort to build a bridge from ruminations to trading. Yesterday’s Hermès vs. Wal-Mart is a case in point. The post generated a fair amount of feedback, including some discussion about possible pairs trading approaches for some retailing ETFs and individual stocks.

The chart below is an adaptation of the Claymore/Robb Report Global Luxury Index ETF (ROB) to Wal-Mart (WMT) ratio discussed in yesterday’s post and incorporates some pairs trading tools found in ETF Rewind, a powerful Excel spreadsheet tool and companion blog that is a sister site to Jeff Pietsch’s popular Market Rewind blog.

The chart shows the potential for a market neutral pairs trading approach using ROB and WMT that incorporates a 4 day lookback period and results in a nice smooth hypothetical profit and loss curve. [Click to view full-sized original graphic]

Readers who are interested in learning more about pairs trading or who are interested in a superb Excel spreadsheet for analyzing ETFs are encouraged to check out in ETF Rewind, which is available with a three day free trial.

[source: ETF Rewind]

Disclosure: I use ETF Rewind on a daily basis and have been so happy with it that I now offer a special annual subscription bundle consisting of VIX and More, ETF Rewind and Quantifiable Edges in a ‘Blogger Triple Play’

Hermès vs. Wal-Mart

Hermès vs. Wal-Mart (WMT); upscale vs. downscale. It hardly seems like a fair fight in these trying economic times. The venerable Paris-based fashion house, whose customers range from traditional royalty to Paris Hilton and Madonna pitted against the world’s largest retailer, the Bentonville, Arkansas-based discounting behemoth, whose customers seem as likely to achieve fame on the Jerry Springer Show as anywhere else.

In fact, it is Hermès and the luxury retailers such as Louis Vuitton Moet Hennessy that have been prospering as of late. Last month, Hermès reported a 12% revenue gain for the second quarter. Today, Wal-Mart weighed in with a 1.4% decline in sales, citing “a sales environment more difficult than we expected.”

For a reality check on some of the relevant stocks, I have included the ratio chart below from StockCharts.com. The ratio tracks a ratio of the Claymore/Robb Report Global Luxury Index ETF (ROB) to Wal-Mart. ROB’s top holdings include Porsche, Daimler (DAI), BMW, Louis Vuitton Moet Hennessy, Hermès, Luxottica (LUX), Pernod Ricard, etc. As the graphic shows, the luxury segment has been dramatically outperforming the discount retailer since the March bottom.

ROB has still not exceeded last Friday’s top on an absolute basis or relative to Wal-Mart. While this fact is not yet noteworthy from a technical analysis perspective, it does bear watching going forward.

For a related post, readers may wish to check:

• Christmas Shopping Strength: Luxury Purveyors vs. Discounters

[source: StockCharts]

Doug Short and a New Look at the Four Bad Bears

While we are waiting to see what the FOMC has to say, I thought I would use this lull to highlight the work of Doug Short, which can be found at dshort.com.

Yesterday, in The Road to Recovery, Doug looked at the profile of recoveries from four strong bear markets. Given the relative ease with which stocks have recovered from their March lows (see chart below), Doug adopts a skeptical tone (which I share) about the path forward for stocks:

“Our current market is now 47% above the March 9th low. It has significantly outperformed the 1974 and 2002 rebounds over the equivalent period, and it briefly surpassed the 48% rally in the 1929 Dow. Will it continue to show resilience?”

For a related post and graphic that puts the above in a different perspective, readers are encouraged to check out Doug’s The “Real” Mega-Bear Quartet 2000.

[source: dshort.com]

VIX Calls Attract Attention

The VIX is up about 7.4% as I type this, to 26.84, as the recent rally is finally beginning to shows signs of running out of steam.

Weakness and stocks and the rise in the VIX has generated some interest in VIX calls, with the September 35s, September 45s and August 37.5 calls attracting most of the action at the ask.

With today’s session not even at the halfway point, VIX call volume is running at a high level and the ratio of VIX calls to puts is considerably higher than the recent trend, as the chart below from WhatsTrading.com reflects. It is difficult to determine whether the VIX options activity reflects new speculation or new hedging activity, but my best guess is that a good deal of the activity is speculative.

Note that VIX options expire one week from tomorrow (see expiration calendar) and have a last trading day of one week from today.

Any close over 26.31 would mark the highest close in the VIX for a month, but it would take a spike all the way to 28.13 to bring the VIX to a level that is 10% over its 10 day moving average.

[source: WhatsTrading.com]

The TAO of Chinese Real Estate

Two places where investors have done extremely well since March are China and real estate. Some investors have undoubtedly been lucky enough to find themselves at the intersection of these two bullish themes by being invested in Chinese real estate.

Historically, gaining significant exposure to Chinese real estate has been at best unwieldy for U.S. investors. In December 2007, however, investors were given a shortcut to Chinese real estate with the launch of the Claymore/AlphaShares China Real Estate ETF, which seeks to match the performance of the AlphaShares China Real Estate Index and sports the slightly-too-cute ticker TAO.

For about a year and a half, TAO received very little attention and struggled to put together an occasional 100,000 share day, but as Chinese stocks rebounded, TAO started gathering a following. For the last two months, volume in TAO has been improving and this formerly niche ETF has started to attract a mainstream following.

Last week, TAO peaked at 20.39, more than 2 ½ times the March low of 8.08. As the chart below shows, since last week’s high, TAO has begun to come under some selling pressure, both on an absolute basis and relative to FXI, the popular Chinese ETF (see top study.) Going forward, TAO is an interesting way to keep an eye on speculative trends in the Chinese real estate market.

Finally, don’t be surprised if Chinese securities start to exhibit more of a bellwether role for global securities.

[Thanks to Market Rewind for bringing TAO to my attention.]

[source: StockCharts]

Chart of the Week: Putting Nonfarm Payrolls in Context

For the sake of the economy and the national psyche, I was just as happy as the next person to hear that Friday’s nonfarm payrolls were better not as bad as had been expected.

The 247,000 jobs lost in July were the lowest since August 2008 and less than half of the job losses suffered in each month from November through April.

I last highlighted nonfarm payrolls in a chart of the week just over two months ago: Chart of the Week: Nonfarm Payrolls, Unemployment Rates and Time. In that post and accompanying chart, I stressed that following the peak job losses of 325,000 in October 2001, it was 19 months before there was a sustained improvement in the unemployment rate and a full 3 ½ years before the unemployment rate was below the October 2001 rate on a sustained basis.

This week’s chart of the week adds two more months of data to the previous chart and highlights another important point about the monthly job report. In the last recession, it was two full years from peak job losses to three months of consecutive net job gains. Further, while the 247,000 job losses sounds like considerable progress in the context of the recent job situation, July would have been the third worst month for job losses during the 2000-2003 bear market.

So while the July employment numbers are undoubtedly a step in the right direction, we are a long way from the type of data that should be a cause for celebration.

[source: Bureau of Labor Statistics]

Around the Horn: VIX, Volatility and Options

Just a quick note as we head into the last hour of trading to highlight several interesting new posts in the world of the VIX, volatility and options:

• Andrew Hart of BigTrends.com notes the arrival of the China VIX in Global Volatility Analysis. (I see BigTrends now also has a blog and an article archive that are also worth checking out to see what Price Headley, Moby Waller, Bob Lang and some of Andrew’s other compatriots have to say.)
• Wayne at Sigma Options has an excellent discussion of historical volatility and some of the different approaches to measuring it in Volatility? What Volatilty?
• Adam at Daily Options Report touches on the Friday effect and notes an interesting VXX divergence in VXX Bikini Friday? (Based on some recent correspondence, it looks as I should be ramping up my posts about VXX.)
• Mark at Options for Rookies has some forthright common sense thinking about expectations for options income streams in Using Options to Create a Steady Income Stream.
• At Don Fishback’s Market Update, Don poses – and answers – the question of Why Do People Think That Leveraged Funds and ETFs Should Closely Track the Index Times the Multiplier Over the Long Term?

Finally, thanks to all who commented and wrote about the Bloomberg TV piece. I appreciate all the kind words and support.

Bloomberg TV, TiVo and the SPX

I had an interesting sequence of events happen to me today. I’m not sure they mean anything, but I thought I’d pass them along for posterity and the remote possibility that it may be of service to someone else further on down the line.

While I am decidedly not a chat room person, in the heat of today’s trading boredom, I decided to drop in the Market Rewind chat room, which is hosted daily by Jeff Pietsch of Market Rewind.

I couldn’t have been in the chat room for more than a minute or two when someone blurted out that I was “just on Bloomberg.” I assumed he meant some sort of mention in an article on Bloomberg.com, but it turns out he was referring to Bloomberg TV. Now I know I had not been out of the house all morning and had not even been on the phone, so this made me fairly curious. When I was unable to pull up anything on the Bloomberg TV web site, it occurred to me that the previous night I might have flipped on Bloomberg Asia before going to sleep. While I don’t know all the nuances of TiVo, I do know that even if you turn of the television, the last half hour or so of programming for whatever station you were watching is stored in a buffer. Perhaps my wife had not turned on the TV and changed the channel today…

So, I dashed upstairs and sure enough, found that Brennan Lothery had mentioned VIX and More as well as the newsletter in a short segment about the possibility of a correction in stocks. Specifically, Lothery picked up on the theme of Monday’s post, SPX 15% Over 200 Day Moving Average for First Time in Ten Years and used a recent chart of the SPX and the 200 day simple moving average to highlight the widening gap between the two.

To the best of my knowledge, this is the first time any VIX and More analysis has been referenced on any of the major financial television stations.

Adam at Daily Options Report noted how the multiple attributions and very positive tone of the Bloomberg segment was in sharp contrast to the almost comically confrontational approach CNBC has taken to bloggers.

While I am pleased to receive the recognition, I find it surreal that I would never have happened upon this without the following very unlikely events falling into place:

1. I decided to wander into a stock chat room for probably the second time in my life
2. I just happened to have Bloomberg TV as the last station I watched out of the 900+ DirecTV channels
3. my wife was occupied all morning and unable to change the TV station
   

Finally, I am left with the thought that it is indeed possible to trap serendipity in today’s electronic fishing net, particularly if you have TiVo and can make a good guess at which channel might snare what you are looking for.

CBOE Equity Put to Call Ratio in Bear Territory

Lately I have been dipping my toe in the water on the short side – only to discover that something resembling an alligator seems intent on severing my leg at the ankle. Fortunately, I have managed to keep the stakes low to this point, but during today’s session I took a much more aggressive stance and bought a large quantity of puts.

In the process of reshaping my thinking, I found two indicators in particular to be persuasive. The first is the TRIN, where I am partial to using a 10 day EMA to smooth the data. Today it closed at a level seen only once since the beginning of 2006, just as the market put in a short-term top after a week and a half of bouncing off of the March lows.

Even more persuasive is the CBOE equity put to call ratio (CPCE), where the 10 day EMA hit a low of 0.51 – a level which has not been seen since the October 2007 top. The chart below shows that a low CPCE warned of excessive optimism and the possibility of a top first in July 2007, when the SPX began to form the first half of a double top and again in October 2007, just as the market was topping for the second and final time.

For a different take on today’s CBOE equity put to call ratio, I can highly recommend 08/05/09 Market Recap: CPCE a little too low again, from Cobra’s Market View.

For some related VIX and More posts on the CPCE, try:

• Put to Call Data at Extreme Levels
  
• CBOE Equity Put to Call Ratio Poised to Print Warning
  

[source: StockCharts.com]

Money Center Banks Surge as Regional Banks Lag

While the S&P 500 index is down about 0.8% as I type this, banks are faring considerably better than the index today, continuing a recent trend. Buying interest across the bank universe is splintered, however, with strong demand for money center banks and less interest in regional banks.

The chart below compares the performance of two popular banking ETFs, KBE, which is based on a broad-based bank index, and KRE, which is based on a regional banking index. The contrast is stark. Not only is KBE up 2.2% today while KRE is down a fractional amount, but this has been a recurring theme since the end of April, when regional banks became a laggard. Note that both banking ETFs have trailed the performance of the full financial sector, as represented by seemingly ubiquitous XLF.

During the last two days, sellers have been unable to put a dent in either real estate or financials. Until this pattern reverses, stocks are not going to be able to correct.

[source: StockCharts]

Real Estate Breaks Out While the Major Indices Pause

A wave of buying in the last ten minutes pushed the major indices to small gains today, following a day of lackluster trading. Stocks caught a bid early in the session following the announcement of a 3.6% increase in pending home sales for the month of June. While the broad indices bounced around near the unchanged mark all day, real estate was strong throughout the day, with IYR, the popular real estate ETF, gaining 4.8% on the day.

The chart below shows today’s action constituted a breakout for IYR, which is now trading at levels not seen since early November. Today’s volume of on volume of 40 million shares was also the highest in more than two months.

Three subsector real estate ETFs posted even more impressive gains than IYR. The FTSE NAREIT Retail Capped Index Fund (RTL) gained 6.0%, while the FTSE NAREIT Industrial/Office Capped Index Fund (FIO) advanced 5.5% and the FTSE NAREIT Residential Plus Capped Index Fund (REZ) added 4.9%. For more on the holdings of these three ETFs, check out Three Commercial Real Estate Sub-Sectors to Watch.

[source: StockCharts]

SPX 15% Over 200 Day Moving Average for First Time in Ten Years

Since I have not seen it mentioned elsewhere (which is not saying as much as it used to, given the expansion of the blogosphere), I thought it worth noting that in addition to closing over the critical 1000 level for the first time since November, the SPX also closed 15% above its simple moving average for the first time since 1999.

In the chart below, I show the daily closes of the S&P 500 index going back to 1970 (blue) and an overlay of the ratio of the SPX to its 200 day simple moving average (red.) With today’s close (red diamond), the SPX is now entering a level where mean reversion trading often makes the SPX vulnerable to a reversal. That being said, the 200 day moving average will be rising at a rate of about 0.40 per trading day for the next month or so, meaning that sideways action or even small gains will help to work off some of the excess in this ratio and bring it back toward a more typical range.

Frankly, I am beginning to think that if we do not see a significant correction begin between now and Friday’s employment report, that the SPX may make a quick move to 1100. Of course it is going to be awfully difficult to bet against the bulls until there is some evidence of an Achilles heel.

Those looking for a related upside target might be interested to know that the SPX has not closed 20% above its 200 day SMA since 1983.

For a related post, try:

• The SPX and the 200 Day Moving Average

[As an aside, I somehow feel compelled to note that I had no intention of making the chart look like the national flag of some new investor nation…]

Chart of the Week: Recent Rising Weekly VIX and SPX

With all of the interest being generated by Friday’s Is the VIX Being Gamed? I thought it might be a good time for this week’s chart of the week to build on a tangential subject: the meaning of a simultaneous rise in the VIX and the SPX. Lately I have heard more than a few observers comment that the recent positive correlation between the VIX and the SPX – specifically the simultaneous rise in each index – is a bad omen for stocks.

Frankly, the SPX:VIX correlation is a subject I have been blogging about since the early days of the blog, with some of the more memorable posts on the subject included in the links below. So far I have published very little on weekly correlation data for the VIX and the SPX, but that is about to change, starting with this post.

The chart below shows weekly bars of the SPX and VIX going back to the beginning of 2008. There have been five instances since the beginning of 2008 in which both the VIX and SPX have risen in the same week (a relatively low number by historical standards largely because a large majority of weeks during this period have seen the SPX lose ground.) All five instances have been flagged with a blue arrow on the chart.

While five instances is a long way from being able to draw any meaningful statistical inferences, I think it is interesting to note that there were two consecutive weeks of gains in both the SPX and the VIX just prior to the sharp drop from September through November 2008. On the other hand, both the SPX and VIX in the middle of March, just as the March to July 2009 rally was gathering steam. Finally, the early June 2009 blue arrow seems to fall at a relatively uneventful time in recent stock market history.

The bottom line: don’t read too much about the SPX and VIX moving up in the same week.

For more posts on this subject, readers may wish to check out:

• Volatility Analysis for July 15, 2009
• Eerie Déjà vu as VIX and SPX Both Jump More Than 2.5%
• Performance Implications of VIX and SPX Divergences
• SPX-VIX Daily Correlation
• More Thoughts and Numbers on the SPX-VIX Correlation
• High Positive Correlation Between VIX and SPX Often Signals Market Weakness

[source: StockCharts]

Disclosure: Long VIX at time of writing.