Four Key Drivers of the Price of TVIX

TVIX (VelocityShares Daily 2x VIX Short-Term ETN) is the new rock star in the VIX exchange-traded product (ETP) space.

Far from being a one-hit wonder, I predicted just two weeks after it was launched (toward the end of 2010) that “TVIX will hit a tipping point and become the darling of day traders.” If anything, I am surprised that it took so long for TVIX to attract this much attention.

With all the new attention, however, comes quite a few new investors who do not fully understand what factors are driving the price of TVIX. I have addressed some of these points over the course of the last week or so, but here are the four key drivers of the price of TVIX that every investor should understand:

1. Volatility – this seems obvious, but in the short-term, the movements of the front month and second month VIX futures explain almost all of the change in the price of TVIX. For day traders, TVIX becomes essentially a substitute for trading the VIX futures and with the exception of leverage, the other factors below are inconsequential.
   
2. Leverage – another obvious factor, the 2x leverage in TVIX means that on average it moves about as quickly up and down in percentage terms as the VIX does and twice as quickly as a basket of front month and second month VIX futures. In the short-term, leverage means mostly that the moves in the underlying are exaggerated; in the long-term, leverage enhances volatility compounding and has a negative impact on price.
   
3. Contango – thanks to the emergence of VIX ETPs as the cornerstone of volatility as an asset class, issues related to the VIX futures term structure in general and contango and negative roll yield in particular have become among the most frequently discussed issues in this space. Simply stated, the front month and second months of VIX futures are in contango more than 75% of the time, with the result being a monthly drag on TVIX’s price that exceeds the current annual yield on the 30-Year U.S. Treasury bond.
   
4. Volatility compounding – the more volatility a leveraged security exhibits, the more that volatility will have a negative impact on performance over an extended period. The issue is the same as someone who owns a dress shop and marks the dress down 50% and then up 50% or reverses the chronology and marks the dress up 50% and then down 50%. Either way, the value of that dress declines by 25%. The same is true for leveraged ETPs and the degree of the price decay is a direct function of volatility.

If you combine all four factors you have a product that is ideal for day trading, as it can skirt the contango and volatility compounding issues in a compressed time frame. For buy and hold investors, however, contango plus volatility compounding is a recipe for big losses.

The graphic below lays out the gamble in visual terms. For the most part, those who are long TVIX for extended periods will be subject to losses that are substantial and persistent, but there is always the chance of catching a brief move in which all four forces are aligned with the bulls and TVIX moves sharply higher, as was the case in August and September 2011. Unfortunately, this is rarely the case.

The bottom line is that if you are already invested in TVIX or are considering an investment in TVIX and do not fully understand each of the four issues above and their impact on investments in TVIX over the short-term and long-term time horizon, then it is probably time to stop trading and increase your knowledge base (hence the links below) before you learn some expensive lessons.

Related posts:

• Will TVIX Go to Zero?
• TVIX Topples VXX as Highest Volume VIX ETP
• Who Is Trading TVIX?
• Volatility Becomes Unhinged on Friday
• VXX Options Calm After Second Highest Volume Day Ever
• TVIX Finally Getting Its Due As Day Trading Rocket Fuel
• TVIX Trades One Million Shares for First Time
• VIX and More and the 2011 Bespoke Roundtable
• VIX Exchange-Traded Products: The Year in Review, 2011
• VXX Calculations, VIX Futures and Time Decay
• Why VXX Is Not a Good Short-Term or Long-Term Play
• Navigating VIX and More by Labels

[source(s): ETFreplay.com]

Disclosure(s): short TVIX at time of writing

Will TVIX Go to Zero?

The sudden surge of interest in TVIX (VelocityShares Daily 2x VIX Short-Term ETN) made it the most heavily traded VIX exchange-traded product (ETP) on Friday, as TVIX vaulted over the former king of the mountain, VXX.

Part of the appeal of TVIX is to retail investors who have embraced this product with surprising swiftness in the last week or two. Some of the appeal of TVIX is a function of its volatility: this is a product that jumped from 15 last August to over 109 in early October, before falling as low as 13 earlier this month. Based on some of the questions I have received, it is also obvious than many new investors in TVIX do not understand the product they are trading.

First things first, for those who are new to TVIX, make sure you understand what VXX is, why it has underperformed for the past three years and why it has shortcomings both as a short-term and long-term investment.  For the most part, TVIX is the equivalent of VXX, with 2x leverage.   [If you start from the bottom of the links below and keep reading up, the key points regarding VXX should come into focus fairly quickly.]

I periodically receive inquiries about whether TVIX, VXX and some of the other VIX ETPs were “designed to go to zero.” This is not the case. In fact, TVIX and VXX can be excellent products for those who wish to benefit from a short-term increase in volatility. It is important to note that these products were designed to be short-term trading instruments only, with the expectation that they would have a much greater appeal to institutional investors than to retail investors.

Unfortunately, over a long-term time horizon, long positions in TVIX, VXX and many of the other VIX ETPs will be a losing proposition. For those who doubt this, read the prospectus for TVIX. Start with the Risk Factors discussion on page PS-26 and make sure you read as far as the first paragraph of PS-28, where you will encounter the following statement:

“The long term expected value of your ETNs is zero. If you hold your ETNs as a long term investment, it is likely that you will lose all or a substantial portion of your investment.”

This is the situation in a nutshell and helps to explain why TVIX is down more than 80% since its launch at the end of November 2010 – in spite of a meteoric 7x rise from July to October of last year. Will TVIX go to zero? No. As is the case with a number of other VIX ETPs, should TVIX continue to decline in price, a reverse split will likely be used to inflate the share price.

Tomorrow I will delve into the four key drivers of the price of TVIX and implications they have for short-term traders and long-term investors.

Related posts:

• TVIX Topples VXX as Highest Volume VIX ETP
• Who Is Trading TVIX?
• Volatility Becomes Unhinged on Friday
• VXX Options Calm After Second Highest Volume Day Ever
• TVIX Finally Getting Its Due As Day Trading Rocket Fuel
• TVIX Trades One Million Shares for First Time
• VIX and More and the 2011 Bespoke Roundtable
• VIX Exchange-Traded Products: The Year in Review, 2011
• Trader Development Stage Model -- Version 2.0
• VXX Calculations, VIX Futures and Time Decay
• Why VXX Is Not a Good Short-Term or Long-Term Play

[source(s): StockCharts.com]

Disclosure(s): short VXX and TVIX at time of writing

The Upcoming 2012 CBOE Risk Management Conference

Last year I had the pleasure of attending the 27^th annual CBOE Risk Management Conference and wrote about that experience in The VIX Summit, a.k.a. the CBOE Risk Management Conference.

Some of my comments on last year’s conference include:

“I have little doubt that if VIXophiles were only to attend one conference per year, this would be the one.”

“Where else can you find several hundred like-minded souls who obsess about the VIX and volatility on a daily basis?”

“Where else could you holler out ‘Hey, Mr. VIX?’ in a crowded room and expect at least a dozen heads to turn?”

The 2012 version of the CBOE Risk Management Conference is being held at the Hyatt Regency Coconut Point Resort and Spa at Bonita Springs, Florida and runs from March 11-13.  This year’s agenda looks to be an interesting one and includes sessions such as:

• Today’s Volatility Environment and What to Do About It
• Options-Based Strategy Benchmarks
• Technical vs. Fundamental Drivers of Volatility
• How to Manage Tail Risk and Add Alpha
• Dispersion and Correlation Trading: What Worked, When, Why, and How?
• Cross-Asset Volatility
• Options Pricing Theory Revisited and the Impact on Long-Dated Index Options
• Smart Hedging and Alpha Generation with VIX Options

In addition, the conference also offers two parallel introductory tracks for investors and traders that consist of three sessions each and are intended to provide those who are relatively new to the subject matter with a strong foundation in advance of the general presentations noted above.

If you trade VIX products and you want to find out what some of the top practitioners in the field are thinking and doing, the CBOE Risk Management Conference is a great place to get that information first-person and do some networking in the process.

To register or get more information, check out http://www.cboermc.com/.

[While a family conflict will prevent me from attending this year’s conference, I intend to make this a conference part of my annual southern migration, as it is in Florida in the even years and southern California in the odd years.]

Related posts:

• The VIX Summit, a.k.a. the CBOE Risk Management Conference

Disclosure(s): the CBOE is an advertiser on VIX and More; VIX and More is a sponsor of the CBOE Risk Management Conference

TVIX Topples VXX as Highest Volume VIX ETP

With just a few minutes before the close, it is now almost certain that TVIX (VelocityShares Daily 2x VIX Short-Term ETN) is going to dethrone VXX as the most heavily traded VIX exchange-traded product (ETP), with TVIX trading 29 million shares and VXX at 25 million.

VXX, which just celebrated its third birthday at the end of January has reigned supreme in volume and assets since the first week it was launched. TVIX has a long way to go before it matches VXX in terms of assets, but the gap is narrowing quickly.

Based on some questions I have received from retail investors, it seems as if many who are new to the TVIX party do not understand the nuances or even the basics of this product – so it looks like another round of education is in order.

For the record, not only has TVIX dethroned VXX, but VelocityShares has also overtaken Barclays/iPath as the #1 provider of VIX-based ETPs in terms of volume. It will be interesting to see how Barclays addresses this in terms of future products.

Related posts:

• Who Is Trading TVIX?
• Volatility Becomes Unhinged on Friday
• VXX Options Calm After Second Highest Volume Day Ever
• TVIX Finally Getting Its Due As Day Trading Rocket Fuel
• TVIX Trades One Million Shares for First Time
• VIX and More and the 2011 Bespoke Roundtable
• Charting the Assets of Volatility-Based ETPs

Disclosure(s): short VXX and TVIX at time of writing

Monitoring VIX Futures and Their Impact on VIX ETPs

This morning was one of those mornings where stocks were up, the VIX was up and some of the VIX futures were up even more than the cash VIX – at least before the latest round of news from Greece hit.

It is on days like these when my inbox invariably receives several questions from traders who are relatively new to VIX exchange-traded products (ETPs) such as XIV or ZIV and cannot understand why these are not moving with the SPX or in the opposite direction of the VIX. The answer, of course, is that these products do not track the SPX or even the cash VIX, but the VIX futures.

The reason many traders have so much difficulty with the VIX futures component of VIX ETPs is that their brokerage account is authorized for stocks and ETPs and in some cases options, but not futures. Further, most stock brokers do not have futures available to trade and a large portion of those who do allow futures trades do not have VIX futures on the menu (largely due to the regulatory split between the SEC and the CFTC, but I digress…)

So what is a VIX ETP investor to do?

Well, VIX futures quotes are always available at the CBOE Futures Exchange (CFE) on their main splash page. Unfortunately, these quotes are delayed 15 minutes.

There are, however, two popular options brokers who also have VIX futures quotes. The first of these, Interactive Brokers (IBKR), is known for their wide range of products available to trade, technology and low transaction costs. They are not known for hand-holding and high levels of customer service. If you already have an account there and know your way around or you are used to figuring out most things for yourself and are partial to a self-service model, this is probably your best bet for VIX futures quotes.

For those who are new to VIX futures and prefer to have a strong customer service safety net, a better choice is probably optionsXpress, which was acquired by Charles Schwab back in March 2011. Optionsxpress has an excellent tool set for the options trader and also has a fair amount of functionality for futures traders. Whereas Interactive Brokers excels at a low-cost self-service model, optionsXpress has more of a high touch model and charges more for the additional service component. In short, optionsXpress is likely to be a better choice for those who are new to futures and VIX ETPs.

Below I have captured a (customizable) VIX futures watch list that I created in optionsXpress and have sorted by last trade date (LTD), as well as a snapshot of one of their streaming charts for the VIX March 2012 futures contract, VXH12. Note the fairly substantial amount of data, as well as a highly customizable chart.

There are other brokers out there, but my hunch is that those who are new to VIX ETPs are more likely to have an existing account with optionsXpress than any of the other stock/options brokers that also let you trade VIX futures. If not, optionsXpress is still a good place to get started in futures and specifically in VIX futures trading.

Related posts:

• VIX Exchange-Traded Products: The Year in Review, 2011
• VXX Calculations, VIX Futures and Time Decay
• Why VXX Is Not a Good Short-Term or Long-Term Play
• VIX Futures Brokers
• VIX Term Structure Evolution Over Last Ten Days
• Capitulation in Back Month VIX Futures
• VIX Futures: What Were/Are They Thinking?

[source(s): optionsXpress.com]

Disclosure(s): long XIV and ZIV at time of writing

Who Is Trading TVIX?

As action in the TVIX heats up again today (up 15% on 21 million shares traded), I gave some thought to who might be trading what I called in this space over a year ago “day trading rocket fuel.”

Fortunately, we have the optionsXpress Trading Patterns feature to help answer this question.

In the graphic below, it appears that TVIX is part of the arsenal of those who favor the high volatility products that are ideally suited to short-term trades. These include the 3x leveraged ETPs (TNA and TZA), the 2x leveraged ETP for silver (AGQ) and a handful of futures products based on the S&P 500, Dow Jones Industrial Average and crude oil. Two high flying stocks are also on the list, Renren (RENN) and BroadVision (BVSN) – the latter of which just happens to be the first or second internet stock I ever purchased, some 16 years ago.

It turns out I cannot type fast enough to keep up with market events. As I was typing this, there appeared to be another short squeeze in TVIX (see VXX Options Calm After Second Highest Volume Day Ever for details on the last one), though the markets seem to be settling back down once again.

Finally, a quick reminder that today is the last trading day for VIX February options. VIX February futures can be traded through tomorrow’s pre-market session, which runs from 8:00 – 9:15 a.m. ET. Both products settle with a special opening quotation (VIX SOQ) at the beginning of tomorrow’s regular trading session.

Related posts:

• Volatility Becomes Unhinged on Friday
• VXX Options Calm After Second Highest Volume Day Ever
• TVIX Finally Getting Its Due As Day Trading Rocket Fuel
• Who Trades the VIX and VXX?
• Optionsxpress Trading Patterns and the VIX

[source(s): optionsXpress.com]

Disclosure(s): short VXX and TVIX at time of writing

VXX Options Calm After Second Highest Volume Day Ever

Options volume in VXX (iPath S&P 500 VIX Short-Term Futures ETN) surged to their second highest level ever on Friday, with 344,777 contracts trading and put volume (56%) outpacing call volume (44%) by an unusually high margin.

The chart below shows the options activity in VXX going back to the beginning of August 2011. Note that record options volume in VXX dates from August 5^th and occurred just before VXX spiked from 30 to the upper 50s. On that day and most of the other high volume days in VXX options the calls (green vertical bars on bottom portion of chart) saw more action than the puts (red bars), as investors were most likely betting on an increase in volatility – or hedging against that potential scenario.

Friday’s volume was unusual, just as it was on January 26^th, in that put volume dominated. On balance, traders generally buy and sell more VXX calls than puts. In today’s session, so far the volumes in VXX options are much lower than they were on Friday and the activity in puts and calls is balanced and relatively calm.

This is not to say that VXX options investors are particularly prescient and should not be considered contrarian sentiment indicators. Instead, I am merely suggesting that there was no panic in Friday’s VIX spike.

In fact, the rumor I heard (via a commenter on the blog) that makes the most sense is that someone who had a position consisting of VIX futures, SPX straddles and the TVIX ETP (and supposedly about 90% of the open interest in TVIX) had their position liquidated by a clearing house – and some of the banks that got wind of what was going on were able to front run that move. Take it all with a grain of salt, but that kind of scenario is a good fit for the prints I saw and the facts as we know them.

Finally, keep in mind that the February VIX futures and options expire at Wednesday’s open. February VIX options are last traded tomorrow, while the February VIX futures are last traded in Wednesday’s pre-market session, from 8:00 – 9:15 a.m. ET.

Related posts:

• Volatility Becomes Unhinged on Friday
• Implications of a Positively Correlated SPX and VIX
• TVIX Finally Getting Its Due as Day Trading Rocket Fuel
• A Monthly Comparison of VXX and VXZ
• VXX Celebrates Third Birthday
• VIX Exchange-Traded Products: The Year in Review, 2011
• VXX Calculations, VIX Futures and Time Decay
• Why VXX Is Not a Good Short-Term or Long-Term Play
• The VIX-VXX Minotaur Trade
• Chart of the Week: VXX vs. VIX
• The Sideways Play [SPX Short Straddle]
• Position Management for SPX Short Straddle
• Managing Risk with a Short VXX Position
• A Conceptual Framework for Volatility Events

[source(s): LivevolPro.com]

Disclosure(s): short VXX and TVIX at time of writing; Livevol is an advertiser on VIX and More

Volatility Becomes Unhinged on Friday

Over the course of the last week, the VIX has risen 21.6% while the S&P 500 index has been essentially unchanged (-0.17%). During this period, the VIX has decoupled from the technical changes in stock prices and become more focused on event risk or event volatility associated with the latest act in the Greek tragicomedy spinoff of the European sovereign debt crisis.

If you are anything like me, you are constantly recalibrating your answer to the perplexing question of just how seriously we should take the possibility of a Greek default. Well, so are the markets. The added complexity is that everyone has to digest the simultaneously changing probabilities of certain events happening, the magnitude of the impact of those events, the potential reverberations over time – and periodically (seemingly daily, often at 3:58 p.m. ET) some important new events to consider.

If anyone has a probability tree diagram of just the Greek portion of the European sovereign debt crisis, I think it would be fascinating to look at these. I’d imagine it would be something like Johnny Appleseed meets Edward Scissorhands.

Getting back to the spiking VIX, the decoupling of the VIX and the SPX became quite notable during Friday’s trading session. In the graphic below, I have captured the full trading day of the SPX and TVIX (VelocityShares Daily 2x VIX Short-Term ETN), which is equivalent to a 2x version of the popular VXX (iPath S&P 500 VIX Short-Term Futures ETN). For the record, TVIX targets 2x the daily return of a portfolio that holds front month and second month VIX futures with a constant average weighted maturity of 30 days.

In the graphic below, I have drawn a large red rectangle around a period of approximately 83 minutes (10:36 a.m. – 11:59 a.m. PT) in which the SPX trended steadily higher, yet TVIX split with tradition and rose in dramatic fashion, logging a gain of 8.9% during the same time frame. For two securities that typically trade in opposite directions, this is a highly unusual decoupling. In fact, decoupling may be understating the change in the relationship, which became completely unhinged during the day. Note the yellow ovals that marked the two low points in the SPX some five hours apart. The SPX was unchanged over the course of these five hours, yet TVIX spiked 15.5% (!) during the same five hours. This is as big of an intraday deviation from the normal negative correlation that I can recall observing.

[source(s): QuoteTracker/TD Ameritrade]

Returning to the 21.6% weekly jump in the VIX while the SPX remained flat, this is not the first time the VIX has taken flight in such a dramatic fashion while the SPX was unchanged. In fact, it just so happens that a little more than three years ago the VIX gained 25% in a week in which the SPX eked out a 0.3% gain. That week was the week of September 15, 2008, when the Lehman Brothers filed for bankruptcy.

Related posts:

• The VIX, Lehman Brothers and Forecasting
• The LEHVIX
• Implications of a Positively Correlated VIX and SPX
• High Positive Correlation Between VIX and SPX Often Signals Market Weakness
• TVIX Finally Getting Its Due as Day Trading Rocket Fuel
• More Thoughts and Numbers on the SPX-VIX Correlation
• VXN:QID Ratio Reflects Unusual Complacency
• SPX-VIX Daily Correlation
• Performance Implications of VIX and SPX Divergences
• Availability Bias and Disaster Imprinting
• Data to Support Availability Bias and Disaster Imprinting Hypothesis
• Expectations, Surprises and Fear in 2011
• A Conceptual Framework for Volatility Events

Disclosure(s): short TVIX and VXX at time of writing

Implications of a Positively Correlated SPX and VIX

For those who missed today’s market action and just looked at the post-mortem reports, today probably looked like just another in a series of uneventful days. For those who were paying attention to the likes of the VIX futures and ETPs based on VIX futures such as TVIX (+10.7%) and VXX (+5.2%), however, the tension in the air was obvious.

But the SPX, DJIA and NASDAQ composite indices were all up today, so what’s the big deal? It turns out that investors are easily spooked if the VIX (+2.6%) and the SPX (+0.1%) both move in the same direction. As the graphic below shows, the VIX and the SPX move in the same direction about 22% of all trading days. I think the real issue behind the concern about the direction of the VIX and the SPX is related to a hypothesis I laid out yesterday in What the VIX Kitchen Sink Chart Says:

“…the general consensus seems to be that stocks just do not deserve their current lofty valuation.  In this type of environment, many investors become particularly susceptible to confirmation bias and scramble to find one or more indicators which will tell them what they have already begun to believe: that a major correction is likely just around the corner.”

The last time I crunched the numbers for VIX and SPX daily correlations, was in May 2007 and in looking at data from 1990-2007, I concluded that a High Positive Correlation Between VIX and SPX Often Signals Market Weakness. When I ran the numbers this time around, it turns out that the market gyrations surrounding the financial crisis of 2008 and subsequent bullish rebound did little to change the overall conclusions.  The full data set (1990-2012) now shows that when both the VIX and SPX are up on the same day, the mean returns for the next 1-100 trading days trail the typical returns for the full data set by a substantial margin and are negative through the first five trading days.

In terms of key takeaways, it now appears that stocks perform best following days when the SPX is down and the VIX is up (the ROI +1 column refers to the performance of the SPX one day hence) and worst on days like today when the SPX is up and the VIX is up.  I have sorted the rows according to ROI +10 and in looking at the date, it is clear to me that some mean reversion is responsible for a good portion of the performance characteristics following the various VIX-SPX daily return permutations.  [For the record, the data in the table below includes Fridays and Mondays, so it is possible that calendar reversion may have had an impact on the results.]

Now I will be the first to admit that stocks are overdue for a pullback, but just because the VIX and SPX both advanced on two consecutive days does not necessarily mean the planets are aligning for an Aquarian selloff. If investors are looking for that market reversal silver bullet, the SPX-VIX correlation data, while bearish, fall short of hinting at a major reversal.

Below is a larger than usual set of links for those who may be interested in digging into the history of some of the SPX-VIX correlation themes in this space.

Last but not least, thanks to sharp-eyed reader Lee, whose sleuthing helped me uncover an errant spreadsheet formula that led to some bad data in an earlier version of this post.

Related posts:

• High Positive Correlation Between VIX and SPX Often Signals Market Weakness
• More Thoughts and Numbers on the SPX-VIX Correlation
• VXN:QID Ratio Reflects Unusual Complacency
• SPX-VIX Daily Correlation
• Performance Implications of VIX and SPX Divergences
• VIX Suggests Investors Don’t Believe Rally Is Sustainable
• Fearogram Maps Recent VIX Complacency
• The Week in Fear
• How Fearful Were We Last Week?
• Volatility Analysis for July 15, 2009
• Eerie Déjà Vu as VIX and SPX Both Jump More than 2.5%

[source(s): CBOE, Yahoo]

Disclosure(s): short TVIX and VXX at time of writing

What the VIX Kitchen Sink Chart Says

One of the more interesting developments of 2012 has been to watch the diminution of the strident bearish narrative that has been focused largely on the collision course between a preponderance of debt and low or negative growth. The bullish beginning to 2012, however, has not prompted many in the way of converts to the bullish camp. Instead, there have been whispers of “…overbought…” that have turned into a soft murmur and are now verging on becoming a loud chorus. Suddenly the general consensus seems to be that stocks just do not deserve their current lofty valuation.

In this type of environment, many investors become particularly susceptible to confirmation bias and scramble to find one or more indicators which will tell them what they have already begun to believe: that a major correction is likely just around the corner.

For better or for worse, a look at the VIX is often one of the first stops for those who are looking for evidence of a market reversal.

In the chart below, I have updated and extended a chart from three years ago that I call my “VIX kitchen sink chart” – as it pokes and prods the VIX in a number of different ways. Standard VIX analysis attempts to determine whether the VIX has strayed too far from historical norms, whether this be in the form of moving averages, Bollinger bands or other mechanisms. I have even included a separate rate of change study (with its own Bollinger bands) and a Bollinger band width study below the main chart in order to provide a couple of additional analytical twists.

The bottom line, however, is this:  if stocks are overbought and a correction is indeed just around the corner, the VIX does not appear to be aware of any such inevitability. Instead, it looks a lot more like business as usual in the land of the CBOE Volatility Index.

Related posts:

• VIX Kitchen Sink Chart
• Combining Bollinger Bands and Rates of Change in the VIX
• VIX Spikes Above 10-Day Moving Average
• Anchoring and a VIX of 20
• Checking for Atheists
• Tight VIX Range Keeps Overbought Signals at Bay

[source(s): StockCharts.com]

Disclosure(s): none

Geography, Focus and Strategy

Way back in 2007, in Bicoastal Trading…Or Are You Trading in the Right Time Zone? I offered some thoughts on my experience trading on the West Coast versus the East Coast. At the time, I speculated that the Mountain Time Zone might be the best place to have a trading life that was seamlessly interwoven with the rest that life has to offer.

In the intervening years, I have made a few trips to Hawaii and am now convinced that at least for those who are content being an end-of-day trader, Hawaii may indeed be the ideal trading paradise – and certainly one with the most alluring geography dividend.

Last month, when I was taking some time away (or mostly away) from the markets, it struck me how much geography has influenced what I focus on, what and how I trade, and more broadly what strategies I implement.

When I am on the East Coast, for instance, I place much more emphasis on the European markets and economic data that is released just before or after the opening bell. I am much more likely to trade futures and focus my attention on the many blue chips whose earnings are released before the market opens. I may even break with tradition and turn on CNBC. In short, I have a much greater BMO focus.

By contrast, when I am on the West Coast, I find that I focus more on the Asian markets (checking in before I go to bed), trade a preponderance of West Coast technology stocks that generally report after the markets are closed and also find myself trading in the after-hours session much more often.

In Hawaii, everything is different. The markets close at 11:00 a.m. (10:00 a.m. during daylight savings time) and my routine switches to glancing at the markets, going out for a run, checking to see if the markets are relatively quiet when I return, showering and going for breakfast, then making any position adjustments just prior to the closing bell. All strategies become end of day strategies and short-term trades are much more likely to be multi-day swing trades than day trades.

In a nutshell, my geography determines where (and when) I focus my attention, and that focus has important implications for what I trade, when I trade it and what my anticipated holding period is for each position. Strategy, therefore, becomes a byproduct of geography.

There is nothing like Hawaii-Aleutian Standard Time to put the world in a different perspective and to serve as a reminder that no matter where you are – either as a visitor or with roots firmly in the ground – it is important to match your strategies and focus to your geography and time zone.

Related posts:

• Bicoastal Trading…Or Are You Trading in the Right Time Zone?
• The Education of a Trader
• Trader Development Stage Model – Version 2.0
• Draft Trader Development Stage Model
• Comfort Zones, Focus and Thinking Like a Biotech Firm
• Can Selling Options Make You a Better Trader?
• A Dozen Things My Trading Accounts are Thankful For
• On Trading Rules and Guidelines

[Future naked options sellers line up for another grueling day of work at Shipwreck Beach, Kauai]

Disclosure(s): none

Economic Data: Divergence or Confirmation for Stocks?

The last time I checked in on the performance of U.S. economic data relative to expectations, some two months or so ago, I observed:

“One could certainly make the case that data underperformed stocks from April to September, but has been outperforming stocks for the last 2 ½ months.

While conventional wisdom says that stocks lead economic fundamentals for 6-9 months, this graphic does not support that idea. Instead, it will be interesting to see which of the two assumes a leading role now that at least some of the European angst appears to be in the rear view mirror.”

With the benefit of hindsight, clearly the stocks have been in the driver’s seat and to some extent, the increase in stock prices has had a positive effect on the economic data. For the better part of January, there was a substantial divergence (see dotted red box in graphic below) between stocks and economic data, with stocks in a marked uptrend, while economic data were falling short of consensus expectations on a regular basis.

It is possible that last week’s nonfarm payroll data and ISM services index marked a turning point in the performance of economic data relative to expectations, yet it is also clear that the data trend still lags the stock price trend by a significant margin.

For this update, I have annotated the graphic with arrows to show where manufacturing and employment have been the economic underpinnings of a rise in stocks. This time around the employment data seem to be moving in the right direction, but manufacturing has had trouble living up to expectations – at least for the past two months.

[Readers who are interested in more information on the component data included in this graphic and the methodology used are encouraged to check out the links below. For those seeking more details on the specific economic data releases which are part of my aggregate data calculations, check out Chart of the Week: The Year in Economic Data (2010).]

Related posts:

• Aggregate View of U.S. Data vs. Expectations
• How Good Has the U.S. Data Been Lately?
• Economic Data Not Supporting Gloom and Doom Forecasts – At Least for Now
• Economic Data Relative to Expectations and Stock Prices
• Continued Lackluster Data vs. Expectations
• Economic Data Frozen Until Next Thursday
• More Upticks in Economic Data vs. Expectations
• Economic Data Trends Improving
• Chart of the Week: Updated Economic Data Trends
• Economic Data Trends in Advance of Nonfarm Payrolls
• Trends in Economic Data Relative to Expectations

[sources: various]

Disclosure(s): none

Suppressing Volatility and The Black Swan of Cairo

First published in the May/June 2011 issue of Foreign Affairs, The Black Swan of Cairo: How Suppressing Volatility Makes the World Less Predictable and More Dangerous is a thought-provoking effort by co-authors Nassim Nicholas Taleb and Mark Blyth to advance the idea the efforts of policy-makers to smooth out the peaks and troughs of volatility actually has the unintended consequence of making the world a more volatile place.

I was reminded of the Taleb and Blyth article when I recently read Suppressing Volatility Makes the World More Dangerous, by Kurt Cobb of Resource Insights. Here Cobb extends the thinking of Taleb and Blyth and argues that not only do efforts to suppress volatility backfire in the economic and political realms, but also in areas such as agriculture and public health.

Of course, I could probably argue that Jeff Goldblum’s ranting against the instability of complex systems in Jurassic Park some two decades ago outflanked Taleb, Blyth and Cobb, but on a week when a low VIX seems to have many vexed, ruminating on the ideas of Taleb, Blyth and Cobb may help readers flesh out some insights into what may lie ahead. Along the same lines, I believe the links below might also contain some provocative and related thought starters.

Related posts:

• Thinking About Volatility
• The Risk Library
• A Conceptual Framework for Volatility Events
• Forces Acting on the VIX
• Fukushima Daiichi and ‘Event Theta’
• Expectations, Surprises and Fear in 2011

Disclosure(s): none

Slaying the Natural Gas Contango Dragon

Yesterday’s post on Natural Gas, Contango and UNG appears to have generated a fair amount of interest across a broad base of readers, so for an encore I have decided to forego the typical collection of dazzling Liszt miniatures and skip directly to more on the ways to benefit from the persistent contango and negative roll yield in natural gas.

Starting with the graphic below, I have plotted the performance of natural gas (red line) and three natural gas ETPs since June 16, 2011:

• United States Natural Gas Fund (UNG) – blue line
• United States 12 Month Natural Gas Fund (UNL) – green line
• UBS ETRACS Natural Gas Futures Contango ETN (GASZ) – pink(ish) line

The reason the graph begins in June 2011 is that it marks the launch of GASZ; the other two ETPs have a much longer track record.

First, note that UNG does not attempt to minimize its exposure to contango. Like many other futures-based ETPs, its objective is to hold a one-month weighted average constant maturity in its portfolio and it does this by buying second month futures and selling front month futures. UNL, launched after UNG, was an attempt by the same issuer to minimize contango by holding twelve months of natural gas futures contracts on the assumption that contango is likely to be steepest at the front end of the futures curve and flatter in the more distant months. As the chart below shows, the recent performance differential between UNG and UNL has been minimal.

The UBS ETRACS product, GASZ, takes a completely different approach and is based on a natural gas futures spread index that shorts the front month and is long some of the more distant months. In other words, this ETP is specifically designed to take advantage of contango. According to UBS:

“The ISE Natural Gas Futures Spread™ Index, through a series of investments in natural gas sub-indices, effectively provides short exposure in front month natural gas futures contracts and long exposure in mid-term natural gas futures contracts. This is achieved by taking a 100% long position in the components of the ISE Short Front Month Natural Gas Futures™ Index, which provides short (or inverse) exposure to the ISE Long Front Month Natural Gas Futures™ Index and an aggregate 100% long position in the components of the ISE Twelfth Month Natural Gas Futures™ Index, ISE Thirteenth Month Natural Gas Futures™ Index and ISE Fourteenth Natural Gas Futures™ Index (33.33% per index), which provides long exposure to the mid-term Henry Hub Natural Gas Futures (NG) futures contracts. The index is rebalanced monthly before the Sub-Indices’ roll process to maintain the 1:1 ratio.”

For more information, check out the GASZ web site and prospectus.

The results, at least as seen in the chart below, show that the GASZ approach has some promise insofar as the last eight months are concerned. To be fair, GASZ is very thinly traded and has yet to inspire a broad group of investors, but here is an approach that is not likely to be correlated with any strategies investors are currently running and has been racking up profits in a sideways (at least for equities) market.

Of course investors can always short UNG, but I believe that in much the same manner that ZIV is undeservedly neglected as an inverse VIX futures contango play, so is GASZ overlooked for the same reasons. These are two ETPs with a lot of potential that deserve a broader audience.

Finally, as a side note, UNG announced late yesterday that it will undergo a reverse 1-4 split following the market close on February 21. Here is a product that is down more than 40% in each of the last three years and is already down more than 21% in 2012. Don’t be surprised if this is not the last reverse split.

Related posts:

• Natural Gas, Contango and UNG
• The ETF Energy Troika
• Natural Gas Implied Volatility Spiking
• VXX Calculations, VIX Futures and Time Decay
• Why VXX Is Not a Good Short-Term or Long-Term Play
• VIX Futures Contango Soars
• ZIV Undeservedly Neglected

[source(s): StockCharts.com]

Disclosure(s): long GASZ and ZIV, short UNG at time of writing

Natural Gas, Contango and UNG

I have talked at length in this space about the contango and negative roll yield issues that plague VXX. Periodically these discussions trigger a question from a reader about the impact of contango on some of the other ETPs.

Just to be clear, as far as ETPs are concerned, contango and backwardation issues are limited solely to those products which hold futures in their portfolio. The large majority of futures-based ETPs are in the commodity space, but in theory at least, any security for which there are futures could end up with a futures-based ETP. Fortunately, ETFdb keeps a handy list of these products at their Futures-Based ETF page.

The main reason why I talk so much about contango in the context of VIX-based ETPs is that the VIX products have a tendency to produce huge levels of negative roll yield (at a rate of 11% per month at the moment in the front two months of the VIX futures) relative to the other products.

Outside of the VIX product space, contango is probably most notorious in crude oil and natural gas – and the two most popular ETPs for these commodities, USO and UNG. Still, contango in these products is generally much smaller than it is with VXX, but right now contango is unusually high in UNG. While contango (front two months) in USO is only 0.4% right now, it is actually at 7.6% per month in UNG.

Note that unlike VXX, which has a daily roll, UNG rolls its entire portfolio over the course of four days per month. Better yet, UNG publishes a schedule of their roll dates, reprinted below, though it does come with the disclaimer, “Roll Dates are projected and subject to change without notice.”

So…while it has already been a great year for those who are short natural gas, it is possible that persistent contango will make short UNG positions even more profitable going forward.

Finally and perhaps most important of all, it is critical to keep in mind that steep contango does not happen willy nilly. Instead, contango is essentially a reflection of where the market expects prices to be headed (net of the cost of carry) in the future. Looked at in this context, UNG contango of 7.6% means that the reason shorts are receiving a 7.6% benefit from the negative roll yield is that the market anticipates prices will rebound 7-8% or so over the course of the next month. Contango and roll yield are not a free lunch by a long shot, but over the long term, if risk can be properly managed, positions that benefit from contango should be able to finance at least a few lunches.

Related posts:

• The ETF Energy Troika
• Natural Gas Implied Volatility Spiking
• VXX Calculations, VIX Futures and Time Decay
• Why VXX Is Not a Good Short-Term or Long-Term Play
• VIX Futures Contango Soars

[source(s): United States Natural Gas Fund]

Disclosure(s): short VXX and UNG at time of writing