VIX and More

Combining Bollinger Bands and Rates of Change in the VIX

2009-11-06T16:21:00.000-08:00

As far as I can tell, I have not yet posted about the use of Bollinger bands in conjunction a rate of change (ROC) indicator to identify volatility breakouts.

In summarizing the action in the VIX over the course of the past two weeks, the chart below captures some of the drama in terms of 10% (solid green) and 20% (solid blue) moving average envelopes. In the six month time frame included in the chart, the moving average envelopes flag last week’s VIX spike as the most powerful since stocks turned up in March. The moving averages also indicate that the VIX low of 20.10 from three weeks ago is the second strongest in terms of penetration of the lower moving average envelopes.

The study below the main chart utilizes a 10-day rate of change function as well as Bollinger bands that are tuned to 20 days and 1.6 standard deviations. Note that in this study both the VIX spike and the prior VIX low represent the largest upward and downward moves in terms of magnitude relative to the Bollinger bands.

The rate of change indicator is a valuable way to measure sharp price moves. When combined with the Bollinger band indicator, it is possible to better identify sharp upward and downward moves, particularly when the underlying has a habit of making sudden large moves, as is the case with the VIX.

For additional posts on related subjects, readers are encouraged to check out:

[source: StockCharts]

Open Thread: How Has Your Trading Changed?

2009-11-05T09:41:00.000-08:00

My recent foray into issues of investor psychology and behavioral finance assumes that traders have learned a number of lessons and/or changed the way they trade as the result of the events of the last year or two.

So...in what ways has your trading changed? What lessons have you learned? How are you different as an investor now than you were before the Lehman Brothers fiasco?

The VIX:VXV Ratio, Availability Bias and Disaster Imprinting

2009-11-04T22:22:00.001-08:00

Once a popular subject in this space, the VIX:VXV ratio appeared to be a casualty of the financial turmoil and record volatility spikes in October 2008, when the ratio spiked to record levels an generated a buy signal that turned out to be nothing short of a disaster.

I was not yet ready to give up on the VIX:VXV ratio, so I was pleased to see that from November to January it generated some helpful long and short signals. In a promising development, on March 2^nd the ratio generated a buy signal just before the markets bottomed. When the VIX:VXV ratio urged caution in June, I had even more reason to be hopeful. Then, once again, the ratio had another big miss, issuing a sell signal in mid-July just after the markets started rallying. To compound matters, instead of moving back toward the neutral zone (between 0.92 and 1.08), the ratio persisted with a bearish recommendation all the way to the October top.

I was just about to consign the VIX:VXV ratio to the “Sometimes Useful But Not Always Consistent” bin, but decided to reconsider when I started thinking about volatility levels in the context of availability bias and disaster imprinting, as well as The Gap Between the VIX and Realized Volatility and VIX Spike and VIX Futures Contango Means… As I see it, all these subjects are related. The realized volatility gap, persistent VIX futures contango and off-center VIX:VXV ratio (see chart below) are all symptoms of a market that is not functioning as it normally does, while availability bias and disaster imprinting are the main causes of this situation.

Further, the fact that the VIX futures term structure is now flat and the VIX:VXV ratio hit a new post-March 6^th high of 1.056 last Friday suggests that the volatility picture may be starting to assume some of its pre-Lehman characteristics – if not exactly returning to a ‘normal’ state of affairs.

Personally, I still think the VIX is a little higher now than realized volatility will be a month from now, but a high VIX relative to realized volatility may turn out to be one of the more persistent effects of the global financial crisis, as each investor has their own personal half-life for how long availability bias and disaster imprinting will cast a shadow on their view of the investment landscape.

For additional posts on some of the above subjects, readers are encouraged to check out:

[source: StockCharts]

Disclosure: Short VIX at time of writing.

Availability Bias and Disaster Imprinting

2009-11-03T23:08:00.001-08:00

After I dashed off The VIX Spike Conundrum, it occurred to me that there might be some aspects of behavioral finance that have contributed to what is now a full year of continued overestimating of future volatility. I detailed this phenomenon in The Gap Between the VIX and Realized Volatility and is also being reflected in up in a VIX:VXV ratio that has been stuck at unusually low levels from mid-July until last week.

In thinking about the various elements of behavioral finance that impair ‘rational’ decision-making and could contribute to excess implied volatility, one factor that immediately comes to mind is availability bias (nicely summarized in Wikipedia.) The global financial crisis and VIX spikes into the 80s were so vivid and memorable – and so thoroughly discussed in the media – that they are all too easy to recall one year later, even though arguably most of the risks associated with a VIX of 80 have since passed.

I do not think that availability bias is the only explanation for recent excess implied volatility. My working hypothesis – which I do not believe has been addressed by the behavioral finance crowd – is that another factor is as work. I call it “disaster imprinting” for lack of a better name. Disaster imprinting refers to a phenomenon in which the threats of financial and psychological disaster were so severe that they continue to leave a permanent or semi-permanent scar in one’s psyche. Another way to describe disaster imprinting might be to liken it to a low level financial post-traumatic stress disorder.

I will do some additional research to test the disaster imprinting theory, but for now I wanted to throw the idea out and see what others think. Has going to the brink of a global financial meltdown impaired our collective ability to assess future probabilities? If so, how long will this impairment last? As always, all comments are appreciated.

For additional posts on related subjects, readers are encouraged to check out:

Disclosure: Short VIX at time of writing.

The VIX Spike Conundrum

2009-11-02T20:57:00.001-08:00

I have been absolutely astonished by the number of comments I have seen in the past few days to the effect that right now is an excellent time to initiate new long positions on VIX options. I am still not sure what is behind most of this thinking, but it seems as if quite a few investors are excited about the VIX breakout, some have adopted a Roubiniesque pervasive pessimism and others clearly are still operating under the shadow of the 2008 volatility spikes.

For all those who think that a VIX spike of 50% is a good time to get long the VIX, my response is that your ship has already sailed.

I gave this post the title of The VIX Spike Conundrum because like a hot Chinese solar stock, a rising VIX seems to be attracting the momentum crowd. Betting that a 50% rise in the VIX is just the beginning of a larger move is a sucker’s bet. In the event that readers find the data in the two studies linked at the bottom of this post not to be sufficiently compelling, I have added a new study that looks at what happens to the VIX following the first time it spikes high enough to close above 30. Not surprisingly, it is yet another example of mean reversion at work.

The graphic below is a histogram that summarizes the future VIX action after an initial close above 30. Of the 51 instances the VIX closed above 30 without having closed above 30 in the previous session, 18 times the VIX closed below 30 on the next day and an additional 12 instances reflect the VIX closing below 30 two days hence. This means that 59% of the time the VIX has surrendered the full distance of the close above 30 as well as some additional territory in just two days. Looking out four days, the VIX has already closed below 30 some 75% of the time, as is shown by the dotted red line.

Note that while 84.3% of the time the VIX has already closed below 30 just six days later, the remaining 15.7% of the instances can make or break a trader. Six times (11.8%) the VIX has remained above the 30 level for at least 23 consecutive days following the first close above 30. This is slightly more than one full options cycle. Prior to October 2008, traders who were short VIX calls could reasonably expect that the VIX was not going to spike any higher than 45, which was the all-time record in the VIX at that time. Now that we have had front row seats to witness the VIX spike above 80 on two separate occasions, I suspect investors overestimate the likelihood of a VIX spike of this magnitude happening again. Short of another acute systemic threat, I would be quite surprised to see the VIX rising over the 45 level.

In the current market environment, the odds favor short volatility positions, such as bear call spreads on the VIX. Long positions in VIX calls are not just low probability plays, but they are very expensive as well. I don’t mind, however, if speculators are eager to gobble these up, as I am glad to have a ready audience to buy some VIX calls.

For related posts on this subject, readers are encouraged to check out:

Disclosure: Short VIX at time of writing.

Chart of the Week: Reverse Engineering a Critical Moving Average

2009-11-01T19:22:00.000-08:00

This week’s chart of the week is a simple reminder that while many of us like to standardize on 20, 50 and 200 day moving averages, these rarely always align perfectly with historical data. In fact, it often makes sense to develop customized moving averages that circumscribe past price action in order to get a better understanding of how current forces acting on stock prices compare to past forces.

One such example is in the chart below. The ‘usual suspects’ of moving averages fail to identify support levels from the July SPX low of 869. When this happens, then a little trial and error can quickly produce exactly which moving average provided support to the underlying. In this case an 85 day moving average did the trick. While I am not saying that an 85 day moving average is the answer to all charting problems, it is reasonable to expect that if the current market downturn penetrates the 85 day moving average, it will be a move that is comparable to or more powerful than the July pullback.

Sometimes data optimization can be a dangerous game, but when it comes to moving averages and charts, optimizing can serve a useful purpose.

[source: StockCharts]

Pullback Surpasses 2009 Mean

2009-10-30T11:02:00.000-07:00

While this might not provide a great deal of comfort to longs, I have updated the VIX and More Pullback Table to reflect today’s selloff. The table shows that the peak to trough drop of 67.98 points (6.2%) in the SPX has exceeded the 2009 average of 5.8%.

As noted previously, a 5.8% pullback from the SPX 1101 established a target low of 1037. Today the SPX has been as low as 1033.38.

Looking at the charts, I would expect to see additional support in the 1015-1020 level should the 1034 mark fail to hold. In the meantime, brave souls who heed the VIX spike history or the strangle pong strategy should have a long bias going forward.

For related posts, readers are encouraged to check out:

[Edit: data updated as of 3:10 ET]

VIX Up 26% to 31.20

2009-10-30T10:46:00.001-07:00

For the record, the VIX only spiked more than 26% on two days during the financial crisis: September 29 and October 22, 2008.

Strangle Pong

2009-10-30T09:18:00.001-07:00

For the moment at least, it appears as if the S&P 500 index has encountered strong resistance at 1100 and strong support just above 1040. Assuming these support and resistance levels can hold up for another three weeks – and that is admittedly a large assumption – then the current market environment sets up nicely for what I like to call “strangle pong” with November SPX options. Essentially, this is an approach where one assumes range-bound trading and sells near-the-money options when the underlying approaches one end or the other of the trading range.

The graphic below outlines one way to approach this type of trade. Specifically, it involves dividing the trading range into three zones (which do not have to be of equal size, they just happen to be in the diagram): an upper end of the trading range in which one sells calls; a lower end of the trading range in which one sells puts; and a neutral zone near the middle of the range in which one takes no action (or perhaps sells both puts and calls.)

In an ideal world, the underlying bounces back and forth between support and resistance just like the pioneering computer game and the options seller captures a high premium each time the underlying approaches the end of the range. Once both puts and calls have been sold, a strangle is established, with the maximum profit and loss zone being defined by the target trading range.

The most important determinant of success in a strangle pong trade is the trading range of the underlying during the life of the trade. Of secondary importance is the volatility of the underlying, where increased volatility will increase the price of the options sold and work against the options seller. This is a position’s vega and is something I will address in future posts.

There are a number of ways on which position risk can be managed, not the least of which is to “buy the wings” (offsetting long put positions below SPX 1040 and offsetting long call positions above 1100) and convert this position into an iron condor. According to the strangle pong approach, right now, with the SPX trading a little below 1050, would be a good time to initiate the first leg of this trade by shorting some SPX 1040 puts. Let’s see how the market moves in the next week or so; I will revisit this strangle pong trading approach at that time.

For additional posts on strangles, readers are encouraged to check out:

The Calendar Effect and Time Decay

2009-10-29T22:19:00.001-07:00

Since the beginning of last year, I have periodically discussed what I call “calendar reversion,” which is essentially a phenomenon caused by the fact that the VIX is priced according to the calendar, but only calculated during trading days. The long and the short of this chronological mismatch is that market makers tend to drop option prices (and implied volatility) on Fridays in anticipation of the coming weekend and raise them on Mondays.

Earlier today, Mark Sebastian of Option911 wrote the best article I have seen on this subject, How Option Time Premium Decays Over the Weekend, in which he detailed his experiences related to weekend time decay and how market makers account for this during the Friday trading day. If you want to understand options pricing dynamics and how to best synchronize a five day clock with a seven day clock, then Mark’s work is absolutely required reading.

Note that Mark’s blog is one of the 15 entries in my new (as of today) Favorite Options Blogs list in the right hand column of VIX and More. In the past couple of months I have found myself going out of my way to assemble a Friday links post in large part to highlight some of the interesting work coming out of several relatively new options blogs. Now that it is no longer just Daily Options Report and VIX and More talking about options, I will do the best I can to incorporate as much of the excellent new information and analysis that can be found in all corners of the blogosphere.

For more on calendar reversion, readers are encouraged to check out:

VIX Spike of 35% in Four Days Is Short-Term Buy Signal

2009-10-28T22:25:00.001-07:00

It has been awhile since I posted one of my VIX studies and given the recent spike in the VIX, today’s action seemed like a good excuse to revisit the idea of VIX spikes as contrarian bullish mean reversion buying opportunities.

Today the VIX closed at 27.91, which is up 34.9% in the four trading days since Thursday’s close of 20.69. Over the course of the 20 year history of the VIX, the volatility index has posted close-to-close four day gains of 35% on 42 occasions. If you strip out the consecutive instances of +35% days, this leaves 27 instances in which the VIX crossed above +35% in four days. I have reproduced the full table of these 27 instances below for several reasons. First, the key takeaway is that from a timing perspective, a long SPX position entered after a 35% spike will generally perform best over the course of a five day time horizon. In the graphic below, the 27 instances average a five day gain of 1.99% vs. a typical five day SPX return of 0.14%, for a 1.85% net differential. While the net differential peaks at five days, it is apparent in just one day and persists for at least fifty trading days.

Not surprisingly, since we are talking about extremely volatile periods, quite a few of the returns are at the tail end of the distribution and are highlighted in green and red. In particular, this contrarian long strategy did an excellent job of timing the bounces off of the lows during the Asian financial crisis in 1997, the Russian financial crisis and Long-Term Capital Management crisis in 1998, the 9/11 World Trade Center attacks in 2001, as well as the technology bottom following the WorldCom bankruptcy filing in 2002.

In contrast to the excellent market timing above, it should also come as no surprise that the four long signals from September and October 2008 turned out to be disasters in the 20-100 day time frame. Over the course of a 3-10 day time horizon, however, these were excellent short-term trading opportunities from the long side. I do wish to point out, however, that if one strips out the last four rows of the tables, suddenly the 100 day time frame has a return of 6.86%, which is 2 ½ times that of the baseline (“census”) return. The obvious conclusion is that the VIX spike buy signal is quite reliable for the short-term, but not as reliable for over longer time frames. This is the key take away from the table and the reason I included the full data set. The secondary conclusion is that VIX spikes are generally good long setups as well, but here the risk is that it precedes a once in a generation or two meltdown that erases a decade or more of returns.

Finally, while it is nice to throw statistics at analogous historical situations, it is important to consider that all it takes is one rogue GDP number to throw a monkey wrench into an attractive set of statistics. Tomorrow should be interesting – and I expect the bulls will be putting a great deal of capital to work no matter how the GDP data falls.

For posts on related subjects, readers are encouraged to check out:

Disclosure: Short VIX at time of writing.

VIX Currently 20% Over 10 Day Moving Average

2009-10-28T12:38:00.001-07:00

At 27.22, the CBOE Volatility Index (VIX) is currently at its highest level since the beginning of the month. Perhaps more importantly, the VIX is at its second highest level relative to its 10 day simple moving average (+20.0%) since the November 20, 2008 all-time high close of 80.86.

Short-term, this is a bullish oversold signal for stocks, but now investors have to be wary that the SPX has also broken its 50 day moving average level of 1050.

Some of my earlier analysis suggested a good target bottom for the SPX is in the 1037-1041 range. With a little more than 20 minutes to go in today’s session, we are just a couple of points away from the top of that range.

Disclosure: Short VIX at time of writing.

VIX Spike and VIX Futures Contango Means…

2009-10-28T08:13:00.000-07:00

Sometimes I like to skate around some of the salient points of volatility rather than to try to hit readers over the head with them, but with the VIX now 16% over its 10 day simple moving average, I hope I am not the only one going short volatility. Specifically, anyone who has been paying attention to my comments about VXX should be looking at opportunities to get short this VIX ETN.

At the moment, not only do short VXX positions have mean reversion going for them, but even with the spiking VIX, the VIX futures are still in contango, meaning that they are upward sloping over time, with the second month more expensive than front month. The chart below shows that while the difference between the second month VIX futures and the front month VIX futures has been declining, it is still substantial, which translates into a meaningful negative roll yield that continues to work in the favor of shorts.

Finally, not too long ago VXX was difficult to short at most brokers. This is not the case any more…

For additional reading on this subject, readers should check out:

[source: FutureSource]

Disclosure: Short VIX and VXX at time of writing.

The Post of the Month: An Informal History of VIX and More

2009-10-27T15:55:00.001-07:00

From time to time I like to look back in the archives of VIX and More to see what I was blogging about during certain past events and to see what issues readers were latching on to. In doing so, it occurred to me that it would be possible to assemble an informal history of VIX and More – and of volatility events in general – by capturing for posterity the most popular post for each month in the blog’s history.

When I redesign the blog, this list will have a permanent home, but for now readers may be interested in reviewing the most read posts for each month this blog has been up and running:

2007

January: What My Dog Can Tell Us About Volatility
February: Four Ways to Play VIX Options Following a Record 64% Move to 18.31
March: A Sentiment Primer (Long)
April: The McClellan Summation Index
May: How to Find the Spiker Before the Earnings Announcement
June: CBOE Put to Call Ratio Poised to Print Warning
July: Using the VIX as a Timing Tool for the SPY
August: Drilling Down on Sector Performance
September: VIX Futures and Recent Market Action
October: Correlation Ideation
November: Brian Overby on Trading VIX Options
December: Thinking About the VXV

2008

January: The Fallacy of the Bearish First Five Days
February: The VIX, VXV and Volatility Expectations
March: Volatility History Lesson: 1987
April: Ten Things Everyone Should Know About the VIX
May: Strong Bear Signal from VIX:VXV Ratio
June: SPY Put Volume Study
July: CBOE Launches “Oil VIX” (OVX)
August: Overview of the U.S. Volatility Indices
September: VIX Spikes and the 2002 Market Bottom
October: VXO Chart from 1987-1988 and Explanation of VIX vs. VXO
November: Prediction: Direxion Triple ETFs Will Revolutionize Day Trading
December: Watch the Baltic Dry Index in 2009

2009

January: Chart of the Week: Change of Trend in Cash Holdings?
February: Regional Banks in Trouble
March: The Possibility of a ‘Stealth Bottom’
April: Lost in Translation: VXX and VXZ
May: Lagging Semiconductor Index Suggests Caution
June: Chart of the Week: Might Recent Volume Bottom Doom Stocks?
July: Triple ETF Options Landscape
August: SPX 15% Over 200 Day Moving Average for First Time in Ten Years
September: Draft Trader Stage Development Model
October: Trader Stage Development Model – Version 2.0

Does the Pullback Have Legs?

2009-10-26T12:47:00.001-07:00

With stocks starting to show some signs of stability in the last half hour of trading, the big question on the mind of investors is how far the current pullback is likely to extend.

In order to address this question, I have updated the (surprisingly popular) table I presented at the beginning of the month in Pullbacks in the 2009 Bull Market. The revised table now shows that the pullback which ran from September 23^rd to October 2^nd resulted in a 5.6% decline from peak to trough, making it the third largest pullback in the S&P 500 index in percentage terms since the beginning of the March rally.

A comparable pullback of 5.6% this time around would put the next bottom in the SPX at 1041. Using an average of 5.8% for the previous seven pullbacks would establish a target SPX bottom of 1037. In both scenarios, today’s low represents less than 60% of the expected distance to the target bottom.

So while we may not be putting in a near-term bottom today, a good guesstimate is that the SPX has about 25 points more to fall if it is to keep up with recent historical norms.

Breaking Down the Weakness in Transports

2009-10-26T11:36:00.001-07:00

Yesterday’s Chart of the Week: Falling Transports looked at the recent weakness in the Dow Jones Transportation Average (DJTA) and included a study of the performance of the index relative to the S&P 500 index.

Today I am going to look under the hood of the DJTA and highlight four often overlooked transportation sub-sector indices:

Dow Jones US Railroad Index ($DJUSRR)
Dow Jones US Airlines Index ($DJUSAR)
Dow Jones US Trucking Index ($DJUSTR)
PHLX Marine Shipping Index ($SHX)

The chart below, which plots each of the above sub-sector indices as a percentage of the DJTA shows that airlines have been the biggest laggard relative to the broader transportation average over the course of the past month, while railroads and truckers have also not been able to keep pace with the DJTA as of late. The relative strength in the transportation sector has come from the marine shippers – a point that is bolstered by the recent strength in the Baltic Dry Index (not shown in the charts.)

While I have yet to see any ETFs for the railroad and trucking sectors, two ETFs that are available are the popular Claymore/Delta Global Shipping ETF (SEA) and the less active Claymore/NYSE Arca Airline (FAA).

For additional posts on the transports and their sub-sector indices, readers are encouraged to check out:

[source: StockCharts]

Chart of the Week: Falling Transports

2009-10-25T23:12:00.001-07:00

For the most part, last week saw some mild negative numbers in most of the major market indices. One particular index that is closely watched by many, however, was particularly hard hit. The Dow Jones Transportation Average (DJTA), an essential component of Dow Theory, fell 5.4% for the week and was particularly hard hit on Friday.

Before the market opened on Friday, two of the three railroads in the DJTA reported earnings and while the bottom line numbers were impressive, investors were spooked by substantial revenue declines. Burlington Northern Santa Fe (BNI) reported a quarterly revenue decline of 27% from the comparable quarter in 2008, while Union Pacific (UNP) reported a 24% drop in revenues for the same period. The weak revenue picture helped to push the DJTA to a loss of 3.5% on Friday and create what looks for now to be a provisional double top in the index in the chart of the week below.

While I am by no means a strict adherent to Dow Theory, I do think the transports are important to watch, particularly when they signal a different economic client than is being reported by the manufacturing sector. The transports will be an important sector to watch going forward.

[source: StockCharts]

Trading Resources: Print and Electronic Magazines

2009-10-23T10:07:00.000-07:00

In keeping with the theme of thinking like a biotech firm and the trader development stage model, I thought it might be helpful to highlight some of the top trading magazines that help to keep new ideas flowing.

Five established monthly print magazines that traders might wish to check out include:

Technical Analysis of Stocks & Commodities – an excellent choice if you are interested in analyzing chart patterns, indicators and trading systems. This magazine is particularly useful if you wish to see the relevant TradeStation, eSignal, etc. code in addition to the analysis
Active Trader – has a strong technical analysis and trading strategy orientation. Expect to see lots of equity curves, including a regular Trading System Lab feature that uses the Wealth-Lab platform
Futures – a broad-based magazine that covers futures, options and forex, with features that emphasize trading strategies and include a healthy dose of options-related material
Tradersworld – competes in the same space as the three magazines above, but for whatever reason, has never made the same impression on me as the others
Stocks, Futures and Options Magazine – the only free magazine in this group, SFO focuses largely on macroeconomic trends and high-level issues related to trading

Two additional electronic magazines – both free – take a direct aim at the options market and offer more options and related comment than the print competition:

Futures and Options Trader – published monthly in PDF format by the Active Trader group, this is a solid resource for the beginning to intermediate options trader
Futures in Volatility – more of a newsletter than a magazine, this is a publication of the CBOE Futures Exchange (CFE) and targets volatility futures, specifically VIX futures. Included in each monthly issue is a commentary section authored by Larry McMillan

Next, I would be remiss in not pointing out two relatively new print/electronic hybrids, both free, that specialize in options content and are available quarterly:

Bernie Schaeffer’s SENTIMENT – published by Schaeffer’s Investment Research, SENTIMENT covers a wide range of options and market sentiment topics, with an appealing mix of features and resources. The magazine can be downloaded as a PDF or delivered to your analog mailbox
thinkMoney – a thinkorswim publication that is mailed to thinkorswim customers, but is available as a PDF to customers and non-customers at the thinkorswim web site. Some of the content is thinkorswim-specific, but there is information that is valuable to a general audience as well

Finally, I feel obligated to pay homage to two high profile casualties of the financial crisis:

Trader Monthly – the glossy lifestyle magazine that oozed trader bling and testosterone
Condé Nast Portfolio – the ambitious business-journalism-meets-hedge-fund-world publication that had its moments as a shining star, albeit briefly

Disappointment Lurks as Volume Surges in VXX

2009-10-22T06:27:00.001-07:00

At the beginning of the month, when I penned Why VXX Is Not a Good Short-Term or Long-Term Play, I figured that would likely be my last word on the subject. Well, I haven’t changed my mind, but I saw myself shaking my head more than a few times yesterday, when the volume in VXX surged to a new record, obliterating the old record by 50%.

Perhaps this time around the new VXX longs were expecting something different, but yesterday’s numbers just reinforce my earlier points. Sure, VXX gained 1.87% on the day, but the VIX gained 6.32%. In other words VXX longs participated in less than 30% of the VIX spike.

Moves like yesterday illustrate some of my thinking about why VXX is not a good short-term volatility play. As I have noted in the past:

“The VXX juice factor (VXX movement as a percentage of VIX movement) shows just how disappointing the performance of VXX relative to the VIX is when the VIX spikes. The bottom line is that when you need it most, VXX is at its worst in tracking the VIX.”

When it comes to speculative or hedging plays using volatility products, VIX options (or futures) are typically the best choice. For short volatility positions, particularly when you see a VIX spike, think about shorting VXX. Those who favor long VXX positions have the odds stacked against them.

For more on the shortcomings of VXX, readers are encouraged to check out:

[source: StockCharts]

Anchoring and a VIX of 20

2009-10-21T08:58:00.001-07:00

I can’t quite decide whether to be delighted or puzzled that so many people seem to care that the CBOE Volatility Index (VIX) is approaching 20. In truth, I feel a little bit of each. When I started this blog, I decided to devote a fair amount of attention to this unusual statistic that very few people were aware of and most that did had stopped paying attention to out of boredom. Of course the VIX was at about 10 then, the markets were awash in liquidity, and following a volatility index felt about as useful as trying to estimate Usain Bolt’s times with a sundial.

Fast forward three years and many things have changed. I can certainly appreciate the role the VIX played in trying to help the masses quantify fear in the midst of the financial crisis. When the VIX hit 50, 60, 70 and 80, these new highs sent a message that the situation was getting worse – or that investors were willing to pay dearly to protect themselves from the many potential disaster scenarios looming on the horizon.

A funny thing happened when the markets started to recover. We started to hear a variety of opinions that the VIX was too low, that substantial risks still remained, etc. The “VIX is too low” argument has been heard for several months now, but it seems to be gathering steam as the VIX approaches 20.

More than 35 years ago, Amos Tversky and Daniel Kahneman wrote a seminal piece on anchoring called Judgment Under Uncertainty: Heuristics and Biases. In the words of the authors:

“In many situations, people make estimates by starting from an initial value that is adjusted to yield the final answer. The initial value, or starting point, may be suggested by the formulation of the problem, or it may be the result of a partial computation. In either case, adjustments are typically insufficient. That is, different starting points yield different estimates, which are biased toward the initial values. We call this phenomenon anchoring.”

This is the same line of thinking practiced by investors who watch GOOG hover around the 450 mark for week after week, thinking they will wait until the stock falls to 400 to buy it on the cheap. The problem is that when GOOG moves over 500, all that anchoring around the 450 has conditioned the brain to think that 500 is too expensive, no matter how much GOOG rallies from that level.

Turning to the VIX, not only have all those readings in the 30s, 40s and 50s been recently imprinted into the investor’s psyche, but so also has all the emotional turmoil associated with the financial crisis and stock market crash. Even if things are better, the argument goes, can they possibly be this much better so soon after the global financial system was teetering on the edge of a cliff? The short answer is that anchoring makes it difficult for many investors to adapt to new price ranges and a new set of circumstances as situations change. It is part of the reason why bulls cling to hope on the way down and perma-bears have difficulty changing their bias when the market bounces. Finally, it is why so many people seem to be incredulous that the VIX is almost down to 20.00 when the lifetime (20 year) moving average for the volatility index is 20.26. In terms of volatility, we are right at the VIX’s lifetime moving average, which means investors are pricing in an average amount of risk and uncertainty – in historical terms – at the moment.

Of course, if one were to be anchored in the last 12 months, the VIX would be at an all-time low. Conversely, if one were anchored in the period from 2004-2006, the VIX would be in the 99^th percentile, almost at an all-time high.

So…pull up the anchor and set your sails for the new volatility environment.

[source: StockCharts]

Diving a Little Deeper into the Strategy-in-a-Box ETFs

2009-10-20T00:38:00.000-07:00

I was sufficiently pleased by the response to my strategy-in-a-box ETFs post that it seems appropriate to launch a follow-up post to address several questions raised or implied by readers. The biggest issues seemed to revolve around the history, performance and holdings of these ETFs. It is also important to understand the nature of the index and/or strategy that the ETF seeks to replicate, as well as the timing and methodology used to rebalance the ETFs. For each of the six aforementioned strategy-in-a-box ETFs, I have therefore also included links to a profile/summary page; the prospectus; a current list of holdings; the Morningstar performance data; and the StockCharts gallery chart:

Elements S&P CTI ETN (LSC) – launched 6/10/2008; rebalanced monthly. More information: profile; prospectus; holdings; performance; chart.
Claymore/Sabrient Insider ETF (NFO) – launched 9/21/2006; rebalanced quarterly. More information: profile; prospectus; holdings; performance; chart.
PowerShares DWA Technical Leaders (PDP) – launched 3/1/2007; rebalanced quarterly. More information: profile; prospectus; holdings; performance; chart.
PowerShares Value Line Industry Rotation (PYH) – launched 12/1/2006; rebalanced quarterly. More information: profile; prospectus; holdings; performance; chart.
PowerShares Value Line Timeliness Select (PIV) – launched 12/6/2005; rebalanced quarterly. More information: profile; prospectus; holdings; performance; chart.
Claymore/Zacks Country Rotation (CRO) – launched 7/11/2007; rebalanced semiannually. More information: profile; prospectus; holdings; performance; chart.

As noted on Sunday, all but LSC have at least two years of a track record. Normally I would not consider this to be a long time, but given that it covers both strong bull and bear markets, I believe it is an appropriate time period from which to draw some conclusions. Perhaps more interesting is the rebalance period, where quarterly rebalancing seems to be the norm. I have spent a fair amount of time playing with various rebalancing methods and at least in my experience, I find it difficult to gain a meaningful edge with quarterly rebalancing.

Finally, it looks as if the strategy-in-a-box moniker is here to stay. I guess it is just a matter of time before I roll out screw top, synthetic cork and real cork strategies. Perhaps then we can turn our attention to the next dimension, Jeroboam, Methuselah and Nebuchadnezzar strategies…

[For all of you who think I may be spending too much time near the fermentation tanks, it was only two years ago that my weekly volatility analysis came with a wine pairing…]

VIX Narrowly Misses New Consecutive Day Decline Record

2009-10-19T16:39:00.001-07:00

After falling for a record-tying ten consecutive days, the VIX narrowly missed setting a new record today when it jumped 0.37 in the 4:00 - 4:15 p.m. ET twilight zone trading period to finish the day at 21.49, +0.06.

In the chart below, which I borrowed from the subscriber newsletter, I offer some data to help put the current decline in an appropriate historical context. Prior to the streak that ended last Friday, the only other time that the VIX fell for ten consecutive days was in April to May of 2005. At that time, the bull market was just beginning to pause for a month and it was not until six months later that bulls began to reassert themselves.

Looking at the other fifteen instances in which the VIX fell at least seven days in a row, a pattern emerges in which following the VIX streak, the S&P 500 index has a tendency to post a slight loss for a week or so, then significantly outperform the historical averages (“census”) for the balance of the periods studied, from 10 to 100 trading days.

In terms of adding an interpretive narrative, think of a streak of the VIX declining for seven or more days in a row as a signal that the markets are recalibrating volatility expectations and paving the way for further advances in an environment of diminished risk. Of course the caveat is that a week or so of mean reversion (i.e., an increasing VIX and a declining SPX) usually serves as a transition from the streak of VIX declines to an extended period of above-average stock market returns.

For a related post, readers are encouraged to check out Steaking – an early VIX and More classic and also an official lighter side selection.

Chart of the Week: Strategy-in-a-Box ETFs

2009-10-18T22:06:00.001-07:00

With interest growing in actively managed ETFs, there is another category of ETFs (and ETNs) out there which I believe has been unfairly overlooked by most investors. I do not have a name for these ETFs, but rather than represent asset classes, sectors, geographies, and other typical ETF constructs, they seek to replicate specific investment strategies. Until someone tags them with a better name, I am going to call them strategy-in-a-box ETFs.

Depending upon how you define the strategy-in-a-box concept, you can find various ETFs that may or may not conform to that definition, but six that clearly fit the profile, have attracted some investor interest and that I try to monitor are:

Elements S&P CTI ETN (LSC) – a long-short commodity technical momentum ETF
Claymore/Sabrient Insider ETF (NFO) – targets companies where there are favorable corporate insider buying trends and recent earnings estimate increases by Wall Street analysts
PowerShares DWA Technical Leaders (PDP) – focuses on companies exhibiting strong relative strength as measured by Dorsey Wright & Associates Technical Leaders Index
PowerShares Value Line Industry Rotation (PYH) – is based on the Value Line Industry Rotation Index, which is derived from Value Line’s measure of stock timeliness and industry timeliness
PowerShares Value Line Timeliness Select (PIV) – unlike the ETF above, utilizes three core Value Line ranking systems that incorporate timeliness, technical ranking and safety
Claymore/Zacks Country Rotation (CRO) – which attempts to track the Zacks Country Rotation Index

What can you do with this motley group of ETFs? For starters, since all have been around for at least 15 months (all but LSC for more than two years), you can see how some of these strategies have worked in real-time bull and bear market conditions. For instance, if you just happened to get bullish on March 9^th, which of the above ETFs would have provided the best returns? The chart of the week below shows that the Claymore/Sabrient Insider ETF (NFO) has led the pack, more than doubling over the course of the past seven plus months. The second best performer has been CRO, the Claymore/Zachs Country Rotation ETF. The PowerShares DWA Technical Leaders (PDP) has returned about the same as the SPX during the bull market. Interestingly, the Elements S&P CTI ETN (LSC) has actually lost money during the strong bull market in stocks.

I will have more to say about these ETFs and about their actively managed ETF cousins going forward. In the meantime, feel free to suggest a better name than strategy-in-a-box…

[source: StockCharts]

Interesting ‘Pseudo VIX Buy-Write’ Trade Idea

2009-10-16T11:56:00.001-07:00

Vance at VIX Based Trading runs a blog devoted largely to using the VIX as a market indicator and as a trading vehicle. I only recently discovered the blog, but have been impressed by the content. As a matter of fact, my favorite post so far just happened to pop up on my screen a few minutes ago. Titled Pseudo Buy-Write on VIX – Long 10 Oct Calls, Short 22.5 Oct Calls, the author describes an innovative way to approximate a VIX buy-write strategy using a vertical spread.

With all the great blogs I am still discovering, it looks as if I am going to have to expand my blogroll once again. Better yet, I think it might be more helpful if I were add a second options-specific blogroll…so look for that change over the weekend. Assuming, of course, the blogroll does not get bought out by Bloomberg first…

TradeKing’s Options Screening Tools

2009-10-15T22:52:00.000-07:00

When TradeKing launched their stock and options brokerage back in December 2005, I was one of the first to sign on. The promise was an inexpensive commission structure, some innovative tools and an emphasis on integrating social media themes into the online experience. In the almost four years since it was launched, TradeKing still differentiates their services along the original three themes and has made increasingly larger overtures to options traders, including a strong educational component.

I have always had a good experience with TradeKing, but I realized today that my account was now growing some moss from extended neglect on my part. Frankly, there have been two relatively basic issues that have kept me at arm’s length over the past few years:

The biggest issue I have is the three hour maximum login period before the website automatically logs me off. As an active trader, unless I can leave my browser window open for a full trading session without having to worry about being timed out just before I want to make an important trade, then I am going to be an intermittent customer at best.
A related issue is the TradeKing login process, which is not keystroke-driven, but mouse-based. This is undoubtedly attractive for the security conscious trader, but not for those who wish to automate the login process and/or never be automatically logged off in the first place.

For the record, I have no problem with enhanced security features, but it would be nice if customers could elect the level of security that is appropriate for their account.

In any event, in surfing around TradeKing, I could not help but notice that there is a liberal sprinkling of iVolatility tools, notably the Volatility Charts; Options Calculator; Probability Calculator; Options Scanner; and Options Strategy Scanner.

Tomorrow being the last trading day for equity options prior to expiration, I thought it might be interesting to use the TradeKing Advanced Options Scanner to give me some trading ideas. Specifically, I decided to look for one day buy-write (i.e., buy a stock and simultaneously sell a covered call) trades, using the scanner to identify near-the-money October calls with implied volatilities of 80 or more.

The top chart below shows the simple scan parameters I used and the bottom chart shows the results of that scan. Looking at out-of-the-money (OTM) calls, I see that Cubist Pharmaceuticals (CBST), which reported earnings after the bell, has October 20s for sale at 0.50, which represents a 2.51% return from today’s close. In fact, all the OTM calls on this list are from companies which reported after the market close today or are scheduled to report results tomorrow morning. Still, the Options Scanner runs in real time and may be able to identify a high potential buy-write opportunity after the open.

In sum, The TradeKing-iVolatility partnership makes some interesting tools available to TradeKing account holders. Going forward, I will be looking to incorporate more TradeKing tools and graphics into the blog.

[Edit: I note that one reader wondered whether this post was some sort of endorsement for TradeKing. On the contrary, my intent is to rotate through some of the main options brokers (thinkorswim, optionsXpress, OptionsHouse and TradeMonster) in order to highlight what I consider to be some of the better features, etc. and give people a feel for some of what is available from each of these brokers. That being said, TradeKing does advertise on the blog from time to time, but so also do all the other brokers listed above, save thinkorswim.]

For related posts on these subjects, readers are encouraged to check out:

[source: TradeKing]