Yield Curve Looks Just Like May 2003

There are several places on the web where you can watch a short time-lapse video that shows the recent history of the yield curve. One of those places is Fidelity’s Historical Yield Curve page.

In reviewing the history of the yield curve on the Fidelity site, I was surprised to see that the current yield curve is almost identical to the yield curve as it stood on May 2003. This may just be a historical coincidence, but May 2003 also represents the beginning of the five year bull market that followed the 2002-2003 bottom. In the graphic below, I have added a blue arrow to mark May 2003, which just happens to be the time that the SPX started making higher highs and confirming that a bullish move was underway.

Recall that the inverted yield curve which began in 2006 and caused considerable consternation among investors, turned out to be an excellent – if somewhat early – predictor of the coming stock market top and subsequent economic malaise. Historically a steep yield curve, such as the one we have at present and saw in May 2003, has generally been a harbinger of better times ahead and is often found at the beginning of economic expansions.

Ten Things Everyone Should Know About the VIX

I have had quite a few requests to present some introductory material on the VIX, so with that in mind I offer up the following in question and answer format:

Q: What is the VIX?
A: In brief, the VIX is the ticker symbol for the volatility index that the Chicago Board Options Exchange (CBOE) created to calculate the implied volatility of options on the S&P 500 index (SPX) for the next 30 calendar days. The formal name of the VIX is the CBOE Volatility Index.

Q: How is the VIX calculated?
A: The CBOE utilizes a wide variety of strike prices for SPX puts and calls to calculate the VIX. In order to arrive at a 30 day implied volatility value, the calculation blends options expiring on two different dates, with the result being an interpolated implied volatility number. For the record, the CBOE does not use the Black-Scholes option pricing model. Details of the VIX calculations are available from the CBOE in their VIX white paper.

Q: Why should I care about the VIX?
A: There are several reasons to pay attention to the VIX. Most investors who monitor the VIX do so because it provides important information about investor sentiment that can be helpful in evaluating potential market turning points. A smaller group of investors use VIX options and VIX futures to hedge their portfolios; other investors use those same options and futures as well as VIX exchange traded notes (primarily VXX) to speculate on the future direction of the market.

Q: What is the history of the VIX?
A: The VIX was originally launched in 1993, with a slightly different calculation than the one that is currently employed. The ‘original VIX’ (which is still tracked under the ticker VXO) differs from the current VIX in two main respects: it is based on the S&P 100 (OEX) instead of the S&P 500; and it targets at the money options instead of the broad range of strikes utilized by the VIX. The current VIX was reformulated on September 22, 2003, at which time the original VIX was assigned the VXO ticker. VIX futures began trading on March 26, 2004; VIX options followed on February 24, 2006; and two VIX exchange traded notes (VXX and VXZ) were added to the mix on January 30, 2009.

Q: Why is the VIX sometimes called the “fear index”?
A: The CBOE has actively encouraged the use of the VIX as a tool for measuring investor fear in their marketing of the VIX and VIX-related products. As the CBOE puts it, “since volatility often signifies financial turmoil, [the] VIX is often referred to as the ‘investor fear gauge’”. The media has been quick to latch onto the headline value of the VIX as a fear indicator and has helped to reinforce the relationship between the VIX and investor fear.

Q: How does the VIX differ from other measures of volatility?
A: The VIX is the most widely known of a number of volatility indices. The CBOE alone recognizes nine volatility indices, the most popular of which are the VIX, the VXO, the VXN (for the NASDAQ-100 index), and the RVX (for the Russell 2000 small cap index). In addition to volatility indices for US equities, there are volatility indices for foreign equities (VDAX, VSTOXX, VSMI, VX1, MVX, VAEX, VBEL, VCAC, etc.) as well as lesser known volatility indices for other asset classes such as oil, gold and currencies.

Q: What are normal, high and low readings for the VIX?
A: This question is more complicated than it sounds, because some people focus on absolute VIX numbers and some people focus on relative VIX numbers. On an absolute basis, looking at a VIX as reformulated in 2003, but using data reverse engineered going back to 1990, the mean is a little bit over 20, the high is just below 90 and the low is just below 10. Just for fun, using the VXO (original VIX formulation), it is possible to calculate that the VXO peaked at about 172 on Black Monday, October 19, 1987.

Q: Can I trade the VIX?
A: At this time it is not possible to trade the cash or spot VIX directly. The only way to take a position on the VIX is through the use of VIX options and futures or on two VIX ETNs that are based on VIX futures: VXX, which targets VIX futures with 1 month to maturity; and VXZ, which targets 5 months to maturity. An inverse VIX futures ETN, XXV, was launched on 7/19/10. This product targets VIX futures with 1 month to maturity. As of May 2010, options have been available on the VXX and VXZ ETNs.

Q: How can the VIX be used as a hedge?
A: The VIX is appropriate as a hedging tool because it has a strong negative correlation to the SPX – and is generally about four times more volatile. For this reason, portfolio managers often find that buying of out of the money calls on the VIX to be a relatively inexpensive way to hedge long portfolio positions. Similar hedges can be constructed using VIX futures or the VIX ETNs.

Q: How do investors use the VIX to time the market?
A: This is a subject for a much larger space, but in general, the VIX tends to trend in the very short-term, mean-revert over the short to intermediate term, and move in cycles over a long-term time frame. The devil, of course, is in the details.

[Last updated on 7/22/2010]

Complacency Up Pre-FOMC

For anyone who follows the VIX, the headline above should not come as a surprise, but here the indicator adds a little color to the story.

The VIX:SDS ratio is something I introduced last August. In essence, it plots the VIX against the 2x inverse ETF of the SPX to help determine to what extent the VIX is just moving in the opposite direction of the SPX and to what extent there is an emotional component – either fear or complacency – in addition to the normal negative correlation.

As seen in the chart below, the VIX:SDS ratio has been largely moving sideways since September, but has been drifting steadily lower since the markets bottomed in March. More importantly, the current VIX:SDS ratio is also approaching levels not sustained since July, when the credit crisis had not yet begun to unfold. Also of interest is the 0.05 differential between the 10 day and 100 day simple moving averages, reflecting that current levels of complacency are the highest in relative terms since the launch of the SDS ETF in July 2006.

As always, where there is excessive complacency, bulls should exercise extra caution.

Odometer Turns Over

I never intended for VIX and More to cover more than a small niche of the blogging universe, so when I saw the unique visitor counter hit another small milestone yesterday, I thought it would be an appropriate time to acknowledge those blogs who have referred the most visitors to this site.

Ranked in order of the number of referrals, I offer a heartfelt thanks to the following:

1. Daily Options Report
   
   
2. Abnormal Returns
   
   
3. The Kirk Report
   
   
4. Headline Charts
   
   
5. Chris Perruna
   
   
6. The Buttonwood Speculator (formerly The Kingsland Report – and it is active again)
   
   
7. Trader Feed
   
   
8. Slope of Hope
   
   
9. The dk Report (currently on a blogging sabbatical)
   
   
10. Afraid to Trade
    
    
11. A Dash of Insight
    
    
12. Trading Goddess
    
    
13. Condor Options
    
    
14. The Big Picture
    
    
15. The Global Liquidity Blog
    
    
16. Quantifiable Edges
    
    
17. The Shark Report
    
    
18. 1Option
    
    
19. Option Pundit
    
    
20. Random Roger

Thanks also to all the readers – no matter how you found your way here from all 145 countries – for all you have contributed to the VIX and More dialogue.

What Is High Implied Volatility?

Readers generally ask much better questions than my rhetorical ones. For that reason, I will see if I can set aside more of my time in this space to answer reader questions.

Recently I received several questions about how to determine whether implied volatility is high and when someone declares IV to be high, what exactly the basis for comparison is.

Ultimately, the assessment of what is high implied volatility is a subjective one, but typically the person attaching the label is making a comparison between current implied volatility levels and a historical range of either implied volatility or historical volatility levels.

To my thinking high implied volatility is best determined according to the following criteria:

1. relative to a lookback period (1 year, 6 months, 3 months or whatever – but be careful with shorter time frames) for previous implied volatility levels
   
   
2. relative to historical volatility (one could argue that the time frames are less important here)
   
   
3. relative to the current implied volatility of peers or a broader group of similar stocks (you hardly ever hear about this, but I think the comparison is relevant)

The most important piece of information to remember is that implied volatility is inherently forward looking and historical volatility is, by definition, backward looking. This is important because traders know when potential market moving events are coming and implied volatility moves accordingly. With historical volatility, on the other hand, it is much too easy to drive a car right into an unseen wall while trying to navigate by looking out the rear view mirror.

When I think about implied volatility levels, I am usually looking at ‘relative volatility’ or implied volatility as a % of the most recent 52 week range. The recent volatility trend, if any, is also worth investigating. I always check the current IV-HV spread, but to switch metaphors, it is generally better to know about the hurricane headed your way than the one that has just passed through. Finally, it is critical to know if important events are just around the corner, such as earnings, an FDA decision, the resolution of important litigation, etc. When evaluating implied volatility for ETFs or indices (and data sensitive stocks, such as financials), upcoming events to focus on would likely be more along the lines of impending government data, proximity to Fed meetings, etc.

For the record, I went back and coded some of the more important archived posts on implied volatility with the implied volatility label. In the future, I will offer up some thoughts on how to interpret implied volatility levels and use some real-time examples.

Implied Volatility Suggests Risk in Financials at Six Month Low

Just yesterday, in Financials Struggle to Establish Momentum, I expressed some concern that the recent relatively weak performance of the financial sector (XLF) did not bode well for any sustainable bull moves. Perhaps the sector overheard me, as today the XLF is up 2% in an otherwise flat market as I type this.

While the price action is ultimately what matters most, there is more to the story than just the prices of the financial stocks. In particular, I am watching the implied volatility of XLF, the financial sector’s bellwether ETF. As depicted in the chart below, the implied volatility (which has a significant fear and anxiety component in it) for XLF is approaching levels not seen since the first week in November.

I consider option traders to be a fairly savvy bunch; if they think that the risk premium in the financial sector is lower than any time in the past six months, I am going to listen – and watch to see what happens to the price.

Financials Struggle to Establish Momentum

Further to my recent comments in The Energy and Materials Rally, I thought it might be interesting to show the relative performance of the financial sector (XLF) versus the SPX. The chart below shows that while the financials helped to drag down the SPX over the past six months or so, it also reveals that any gains that the SPX has been able to make over the past 2-3 weeks have been without the participation of the financial sector.

I am of the opinion that while the technology (XLK) and industrial (XLI) sectors can provide leadership in any bull move up from current levels, such a move will be severely hampered and likely short-lived without the participation of the financial (XLF) and consumer discretionary (XLY) stocks.

BIDU Speculators

When I first looked at the optionsXpress trading patterns (“People Trading ___ Also Traded ___”) function back in September, I certainly did not expect that it would become a recurring feature on the blog.

I did, however, have the good fortune of selecting Baidu (BIDU) as my example stock and came up with a good list of speculative companies – all of which were taken to the woodshed at the end of October and sold aggressively over the past six months or so.

Here we are in April and the market has put in a provisional bottom and lo and behold, BIDU is up over 70% in the past month. So, I asked that same rhetorical question once again and optionsXpress was kind enough to oblige me with a list of companies that BIDU speculators have been pushing up over the past month. [All optionsXpress customers can do the same for any security by going to the Quotes tab, clicking on Quote Detail, then clicking on the People Trading… link under the chart on the right.]

There are no real surprises on my end this time around, save perhaps the inclusion of two financial plays, MER and XLF, though it is interesting to see how the list has changed since the last time I did this, which just happened to be on October 30, 2007, at the time the markets were peaking.

The Energy and Materials Rally

While Google (GOOG), Caterpillar (CAT), and other big technology and industrial names have recently helped push stocks to their best levels in three months, the rally off of the March 20^th bottom may not have the kind of sector composition behind it that is conducive to an extended move. In fact, so far the bull run has been largely the result of strong performance in the energy and materials sector – a good portion of which can be attributed to the search for a hedge against inflation.

The chart below shows the performance of the nine AMEX Select Sector SPDRs relative to the S&P 500 index since the March 20^th bottom. The sectors normally associated with an economic turnaround – technology (XLK), industrials (XLI), and consumer discretionary (XLY) – have heretofore not been leading the charge. On the other hand, the leading sectors over the past month – energy (XLE) and materials (XLB) – are not the sectors that typically are able to lead a sustainable rally. In the next week or two, look for other sectors to start outperforming the energy and materials group. If this fails to happen, there will probably not be sufficient market breadth to keep the current rally alive.

VIX Numbers and Overbought Signals

From the looks of some of the Google searches that have been attracting readers to the blog today, it appears that a sub-20 VIX that is more than 10% below the VIX’s 10 day simple moving average has a lot of people wondering about overbought signals.

I have talked about various rules (MarketSci rule, Trading Markets 5% rule, etc.) which utilize the VIX to signal overbought and oversold conditions and I can summarize my thinking briefly here:

• Focus on the relative values of the VIX (i.e., with respect to a recent trading range) instead of absolute values
• Consider the cash VIX in the context of expectations for future volatility
• The more extreme readings give more reliable signals
• History favors mean reversion for the VIX
• Mean reversion does not always happen quickly, so scale in to a position
• If you follow good risk control, VIX signals are one of the few ones for which it is acceptable to add to losing positions (assuming the mean reversion signal is still valid)
• Be sure to start taking profits in no more than 1-2 weeks
  

So…that is my thinking. A sub-20 VIX? Not really relevant. A VIX more than 10% below the 10 day SMA? Generally tradeable. A better signal? While it is still too early ‘cling tightly’ to the VXV (an index that calculates the 93 day implied volatility for the SPX options), I am bullish on the VIX:VXV ratio – and the chart of that ratio suggests that the market is approaching an overbought condition.

Citigroup and Implied Volatility

Consider for a moment that much beleaguered Citigroup (C) is going to report earnings tomorrow morning on options expiration day.

Shouldn’t implied volatility tell us something about how anxious investors should be? Well, that is indeed the case, but the story is not perhaps what one might expect. If implied volatility is to believed, anxiety about Citigroup’s plight peaked about a month ago (when the stock market bottomed) and has been declining ever since. At current levels, Citigroup’s implied volatility is at the lowest level it has been in the past six weeks.

I have included Citigroup’s three month implied volatility chart below, as it is too interesting to let this one go and should make nice fodder for the archives.

Zooming Out on Consumer Spending

By now the news that the University of Michigan Consumer Sentiment Report for April was at the lowest level since March 1982 has been almost fully digested. A number of bloggers have done an excellent job pointing out that lows in this index often coincide with lows in the stock market. Babak at Trader’s Narrative , for instance, has an excellent graph of sentiment and stocks in Consumer Sentiment Always Darkest Before the Dawn. Don Fishback’s Market Update has a similar chart up today.

The upcoming Pennsylvania primary notwithstanding, I am going to set aside poll data for the moment and focus on one of my favorite consumer sentiment indicators: a comparison of consumer discretionary stocks to consumer staples stocks. This can easily be done with two sector ETFs, XLY (Consumer Discretionary Select Sector SPDR Fund) and XLP (Consumer Staples Select Sector SPDR Fund.) Keeping in mind that stocks are supposed to lead the economy by 6-9 months, the XLY:XLP ratio should tell us something about how stocks are pricing in expected consumer spending patterns over the next 2-3 quarters.

The XLY:XLP chart below is a weekly chart, which provides a sense of the recent ebbs and flows of consumer spending patterns. The chart demonstrates that when the ratio trends down and/or makes a significant low, these events usually coincide with market bottoms. It remains to be seen whether this pattern will hold in the current economic environment, but there are signs that the consumer discretionary ratio, like equities, is starting to move off of the recent bottom. This is an important ratio, not just for what it suggests about future consumer spending patterns, but also for flagging the extent to which investors feel compelled to favor the more defensive consumer staples stocks or the more speculative consumer discretionary ones.

Measuring Stress in the System

Historically, the VIX has been an excellent proxy for measuring the level of anxiety and stress in the financial markets…but not always the best one.

Back in early March 2007, I suggested credit default swaps – and particularly the Markit indices – as a way to monitor how the markets are pricing in the risk of defaults. Another common way to monitor default risk is to look at the yield spread between corporate bonds of various rating categories versus the (presumably) riskless US Treasury debt of comparable maturity.

Let me nominate a third alternative: LIBOR rates. LIBOR (formally the London Interbank Offered Rate) is essentially the established rate at which banks lend to each other. Normally LIBOR rates track the Fed Funds rates fairly closely, but lately the LIBOR rates have remained elevated even as the Fed has acted to cut rates and attempted to inject liquidity into the system. If you want to get a sense of how effective the Fed has been in easing tight credit, LIBOR rates (and the "TED spread," which is the difference between LIBOR and the Fed Funds rate) are a good place to start. As the chart below shows, even though LIBOR rates may have topped a month ago, they remain quite elevated when compared to the August-December period.

For more detailed discussion of LIBOR, the Fed, and the current credit crisis, a good place to start is Michael Shedlock’s Failures of the Term Auction Facility – which is decidedly not for the faint of heart.

Financials Testing Critical Support Level

This morning, State Street (STT) reported a $3.2 billion loss on its investment portfolio and an additional $2.5 billion loss on conduits, then was placed on Ratings Watch Negative by Fitch Ratings, signaling that Fitch will review the company’s credit rating for a possible downgrade.

While the State Street news put a damper on financial stocks, XLF, the most widely followed ETF for the financial sector, is trading up as a write this. Earlier in the session, XLF tested an important March 31^st low of 24.40 (see chart below) and has since bounced back. The 24.40 level is an important support level for the XLF and one to watch closely, particularly as tomorrow brings additional earnings reports from J.P. Morgan Chase (JPM) and Wells Fargo (WFC), as well as several smaller banks.

Three Top Bloggers Look at the VIX

Since what little ‘analysis’ there is of the VIX is usually of the quick and dirty variety, I was delighted to see that three bloggers who I have a great deal of respect for just happen to be featuring articles on the VIX this morning.

The first piece, from Condor Options, asks a basic question that I often grapple with when it comes to volatility indices: Is the VIX Impervious to Technical Analysis. I have to say that I am largely in agreement on the three main points made in the post:

• Support and resistance don’t matter
• Long term moving averages don’t matter
• Correlation does not imply causation

That being said, in my opinion there are quite a few ways in which technical analysis can be applied to the VIX, but the universe of valid approach is much smaller for the VIX than it is for other indices. Part of the problem, as I have stated here on several occasions, due in part arises from the fact that in the case of the VIX, one cannot trade the underlying directly.

Ian Woodward is clearly of the camp that one can apply technical analysis tools to the VIX. In Whither Goes the Volatility Index – VIX, Ian lays out a detailed TA approach for looking at the VIX and interprets the implications for the markets based on various trading ranges for the VIX this week. I think there is some validity to Ian’s approach, but this is not how I generally use the VIX.

Last but not least, Tom Drake has an indicator that he calls the 2CS, which combines the VXO (the original VIX, prior to the 2003 modifications) and the CBOE combined put to call ratio to get a two dimensional view of options sentiment. In The 2CS Revisited, Tom discusses how he uses the 2CS to help identify market bottoms. His approach appears to be similar to mine in many respects. Also, the 2CS is clearly a relative of the OSI (Options Sentiment Indicator) that I publish and discuss in my subscriber newsletter.

I suspect the increased interest in the VIX is a by-product of the ongoing discussion in many circles that the VIX has not spiked enough to signal a textbook capitulation bottom, particularly given the magnitude of the macroeconomic concerns. I continue to think that while a VIX spike of 40 or more would placate many of those who are waiting for a more obvious sign of capitulation, this is not necessary to confirm a bottom, particularly given the current trading range of the VIX in the low to mid-20s.