The Volatility Index (VIX) is Getting Interesting Again

In the last observation I shared on the CBOE Volatlity index (the VIX) I had been pointing out last year the VIX was at a low level and then later started trending up. At that time, many volatility traders seemed to think it was going to stay low and keep going lower – I disagreed. Since then, the VIX has remained at a higher average than it had been – up until now. You can read that in VIX® gained 140%: Investors were too complacent.

Here it is again, closing at 12.45 yesterday, a relatively low level for expected volatility of the S&P 500 stocks. Investors get complacent after trends drift up, so they don’t price in so much fear in options. Below we observe a monthly view to see the bigger picture. The VIX is getting down to levels near the end of the last bull market (2007). It could go lower, but if you look closely, you’ll get my drift.

Chart created by Shell Capital with: http://www.stockcharts.com

Next, we zoom in to the weekly chart to get a loser look.

Chart created by Shell Capital with: http://www.stockcharts.com

Finally, the daily chart zooms in even more.

Chart created by Shell Capital with: http://www.stockcharts.com

The observation?

Options traders have priced in low implied volatility – they expect volatility to be low over the next month. That is happening as headlines are talking about stock indexes hitting all time highs. I think it’s a sign of complacency. That’s often when things change at some point.

It also means that options premiums are generally a good deal (though that is best determined on an individual security basis). Rather than selling premium, it may be a better time to buy it.

Let’s see what happens from here…

Volatility Index VIX Shows Implied Volatility is Lower In September

Although September is often the worst month of the entire year for the stock market, so far, August was worse. And, The term structure for VIX shows that implied (or expected) volatility was actually higher in August than September. We’ll see how it all unfolds…

VIX-VXN1

Source: http://www.cboeoptionshub.com/wp-content/uploads/2013/09/VIX-VXN1.jpg

What is the VIX Suggesting about Investor Complacency and Future Volatility?

The CBOE Volatility Index® (VIX® Index®) is a key measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices. Since its introduction in 1993, theVIX® Index has been considered by many to be the world’s premier barometer of investor sentiment and market volatility.

The VIX® historically trends between a long-term range. An extreme level of the VIX® will likely reverse … eventually. The chart below we show the price level of the VIX® since its inception in 1993. We can visually observe its long-term average is around 20, but (I highlighted in red) its low range is around 12 and it has historically spiked as high as 25 or 60.

VIX Since its introduction in 1993, the VIX Index has been considered by many to be the world's premier barometer of investor sentiment and market volatility

The CBOE Volatility Index®  is an index that cannot be invested in directly, however, there are futures, options, and ETN’s that attempt to track it. Its level is commonly used as a gauge of investor sentiment. An extremely high level of the VIX® means that options traders are paying high premiums for options because they are fearful of future volatility and maybe lower stock prices. Options traders and investors are buying options to hedge their portfolios and their demand drives up the “insurance premium”.

Just the opposite is the driver of an extremely low level of the VIX® like we see today. It means that options traders are paying low premiums for options because they are not so fearful of future volatility and lower stock prices. They are unlikely buying options for hedging and their low demand drives down the “insurance premium”. We could also say “investors are complacent” since they aren’t expecting future volatility to increase or be higher.

These levels of complacency often precede falling stock markets and then rising volatility. When stock prices fall, volatility spikes up as investors suddenly react to their losses in value. Or, in the short term volatility could trend even lower and reach an even more extreme low level for a while. But the VIX® isn’t an index that trends for many years in one direction. Instead, as we see in the above chart, the VIX® oscillates between a low and high range so can expect it to eventually trend the other way.

We shouldn’t be surprised to see at least some short-term trend reversals; maybe stocks trend down and the VIX® trends up…

We’ll see…

There is much more to the VIX® , such as it’s term structure, but the scope of this article is to point out its extreme low level could be an indication of future change.

If you are like-minded, believe what we believe, and want investment management, contact us. This is not investment advice. If you need individualized advice please contact us  or your advisor. Please see Terms and Conditions for additional disclosures.

Volatility ETF Strategy

An ETF Volatility Trading Strategy takes long or short exposure to implied volatility through exchange traded securities. A Volatility Trading Strategy is typically a relative value / countertrend strategy applied to an exchange traded fund (or derivates) that intends to get long volatility positions when implied volatility is below relative to historical volatility and short volatility positions when implied volatility is high relative to historical volatility. A Volatility Trading Strategy typically applies this strategy to Exchange Traded Funds (ETFs) or derivatives the track the VIX.

VIX is a trademarked ticker symbol for the Chicago Board Options Exchange Market Volatility Index, a popular measure of the implied volatility of S&P 500 index options. Often referred to as the fear index or the fear gauge, it represents one measure of the market’s expectation of stock market volatility over the next 30-day period.

To learn more, read:

Understanding the VIX

Asymmetric VIX

Keywords: VIX, market volatitility, fear gauge, barometer of fear

VIX® gained 140%: Investors were too complacent

Several months ago I started sharing some of my observations about the VIX ( CBOE Volatility Index). The VIX had gotten to a level I considered low, which implied to me that investors were too complacent, were expecting too low future volatility, and option premiums were generally cheap. After the VIX got down to levels around 11 and 12 and then started to move up, I pointed out the VIX seemed to be changing from a downward longer term trend to a rising trend.

As I was sharing my observations of the directional trend and volatility of VIX that I believed was more likely to eventually go up than down, it seemed that most others were writing just the opposite. I know that many volatility traders mostly sell volatility (options premium), so they prefer to see it fall.

As you can see in the chart below, The VIX has increased about 140% in just a few weeks.

VIX october

Chart courtesy of http://www.stockcharts.com

For those who haven’t been following along, you may consider reading the previous observations:

A VIX Pop Then Back to Zzzzzzzz? We’ll see

Asymmetric VIX

VIX Shows Volatility Still Low, But Trending

VIX Back to Low

The VIX is Asymmetric, making its derivatives an interesting hedge

Is the VIX an indication of fear and complacency?

What does a VIX below 11 mean?

What does the VIX really represent?

The VIX, my point of view

The VIX, as I see it…

Volatility Risk Premium

Declining (Low) Volatility = Rising (High) Complacency

Investors are Complacent

 

A VIX Pop Then Back to Zzzzzzzz? We’ll see

The chart and table below from Russell Rhoads at VIX Views shows an interesting visual of yesterdays increase in the VIX spot index and its futures. The chart is the VIX term structure for the VIX futures. The blue line is yesterdays term structure and the red line the day before. A term structure chart shows how the futures are priced over time. Notice the bottom goes from from left to right August 2014 to April 2015. That corresponds to the table below it, which shows the VIX (spot index) and then each months futures starting with August 2014 (the front month).

VIX Views VIX-Curve

source: http://www.cboeoptionshub.com/wp-content/uploads/2014/07/VIX-Curve.jpg

A Few Observations

The term structure shows how the curve shifted up yesterday. That is, the VIX futures increased August 2014 through April 2015 expiration dates. Notice the VIX spot index gained 27% while the August month gained 12%. When we speak of the VIX, we speak of the CBOE Volatility Index. We can’t actually trade the index, so exposure is gained through futures and options. This is a good time to point out how much the VIX spot index gained and how much less the futures moved. In the table below the chart you can see the % gain. The front month (August) gained 12.18%. The nearer months gained more than the expiration months farther out. I think Rhoads correctly points out that the options market seems to be expecting a quick pop in the VIX and then back to Zzzz. I say that because the August front month contacts gained 12% the months farther out in time had a much smaller increase in expected volatility. It’s another example of complacency. Investors aren’t so concerned about risk enough to pay up to insure it beyond this month. In this low vol environment over the pas year, increases in volatility have been quick and sharp, then revert back to lower levels. So the market seems to be following the trend that way. That works, until it doesn’t.

Let’s see how it plays out this time.

 

Asymmetric VIX

In The VIX is Asymmetric, making its derivatives an interesting hedge I explained how the CBOE Volatility Index (VIX) tends to react with sharper and with greater magnitude than stock indexes. There is an asymmetric relationship between stock index returns and the VIX. Below includes yesterdays action when the S&P 500 stock index was down 2% and the CBOE Volatility Index (VIX) spot gained 27%. The chart is a good visual of how, when the stock index falls, implied volatility spikes up.

 

asymmetric vix

source: http://www.stockcharts.com

I have been sharing some observations about the VIX recently because it had gotten do a low level not seen in many years. It’s an indication that investors have become complacent about risk. When a trend gets to an extreme, it’s interesting to observe how it all plays out.

 

 

VIX Shows Volatility Still Low, But Trending

It seemed that many of the commentators who write and talk about the VIX started talking as though it would stay down a long time. Of course, that’s as much a signal as anything that the trend could instead change.

Below is a chart of the CBOE Volatility Index (VIX) since I observed “VIX Back to Low” on July 3. It says to me that volatility, is, well, volatile. It trended up as much as 34% and then retraced much of that.

cboe volatility index vix pop

source: http://www.stockcharts.com

CBOE VOLATILTY INDEX VIX

Looking back the past several months, we can see since the beginning of July it has started to make higher highs and higher lows. Volatility (and therefore some options premiums) are still generally cheap by this measure, but from the eyes of a trend follower I wonder if this may be the very early stage of higher vol. We’ll see…

Either way, whether it stays low or trends back up, the monthly chart below shows the implied volatility in options is “cheaper” now than we’ve seen in 7 years, suggesting exposures with options strategies may be a “good deal”.

long term vix

Volatility Risk Premium

Following up from “VIX Back to Low” I wrote last week, sure enough: the volatility index has gained 20%. Since last week it has been a good time to be long volatility and a bad time to be short volatility. Many professionals who trade volatility as their primary strategy mostly sell it to collect the Volatility Risk Premium. To do that, they have to be willing to experience gaps like this.

VIX CBOE VOLATILTY INDEX JULY

 

VIX Back to Low

It isn’t unusual for the CBOE Volatility Index (VIX) to drop before a weekend and then pop on Monday morning. That is especially true before a long weekend for those who are concerned with Theta (time decay). Since options are deteriorating assets, their value declines over time. As an option approaches its expiration date without being in the money, its time value declines because the probability of that option being in the money (profitable) is reduced. The more time to expiration, the more time it has to be profitable. With less time, the probably is lower it will ever swing high enough. Theta is a ratio of the change (relative strength) of an option price to the decrease in time to expiration.

With that said, the VIX reached its prior low today. Here is what it looks like on a daily chart:

VIX daily 2014-07-03_16-17-30

Below we zoom in with an hourly chart for a closer view:

VIX 2014-07-03_16-16-49

You may notice the last time it reached this level it gained nearly 20% quickly. The swings in implied volatility are very significant. We’ll see next week if it does it again. Or, if it is on its way to single digits.

 

The VIX is Asymmetric, making its derivatives an interesting hedge

Asymmetric payoff VIX

The VIX is asymmetric, its distribution is non-symmetrical, it is skewed because it has very wide swings. The volatility of volatility is very volatile. There is an asymmetric relationship between stock index returns and the VIX. This asymmetric relationship is what initially makes the VIX interesting for hedging against S&P 500 volatility and losses.

Since I started the series about the extremely low VIX level Monday, like The VIX, as I see it…, The VIX has gained 17% while the S&P 500 stock index has lost about 1%. The VIX is asymmetric. While the VIX isn’t always a perfect opposite movement to the stock indexes, it most often does correlated negatively to stocks. When stocks fall, the implied (expected) volatility increases, so the VIX increases. Asymmetry is imbalance: more of one thing, less of the other. For example, more profit potential, less loss or more upside, less downside.

An advantage of the VIX for hedging is that it is asymmetric: it increases more than stocks fall. For example, when we look at historical declines in the stock index we find the VIX normally gains much more than the stock index falls. For example, if the stock index declined 5% the VIX may have gained 30% over the same period. That ratio of asymmetry of 6 times more drift would allow us to tie up less cash for a hedge position. Of course, the ratio is different each time. Sometimes it moves less, sometimes more.

When the VIX is at a low enough level as its been recently, the asymmetric nature of the VIX makes it an interesting hedge for an equity portfolio. The best way to truly hedge a portfolio is to hedge its actual holdings. That’s the only true hedge. If we make a bet against an index and that index doesn’t move like our positions, we still have the risk our positions fall and our hedge does too, or doesn’t rise to offset the loss. I always say: anything other than the price itself has the potential to stray far from the price. But the asymmetry of VIX, its potential asymmetric payoff, makes it another option if we are willing to accept it isn’t a direct hedge. And, that its derivatives don’t exactly track the VIX index, either. None of the things we deal with are a sure thing; it’s always probabilistic.

This week has been a fine example of vix asymmetry. The chart below shows it well.

 

The VIX is Asymmetric

chart source: http://www.stockcharts.com

 

Note: The VIX is an unmanaged index, not a security, so it cannot be invested in directly. We can gain exposure to the VIX through derivatives futures or options. This is not a recommendation to buy or sell VIX derivatives. To determine whether or not to take a long or short position in the VIX requires significantly more analysis than just making observations about its current level and direction. For example, we would consider the term structure and implied volatility vs. historical volatility and the risk/reward of any options combinations.

The VIX, my point of view

I believe we are naturally attracted to a strategy based on our personality. I am a trend follower most of the time, until the trend gets to an extreme. That is, I identify the directional drift of a price trend and intend to go with it. If it keeps going, I’ll usually stay with it. If it reverses the other way, I’ll exit. I completed scientific research over a decade ago that led to what I believe, and I have real experience observing it. I prefer to ride a trend until the end, but I notice when they start to bend. Or, maybe when it becomes more likely.

Before it bends, I may start expecting the end. I usually notice certain things that alert me the end is nearing. If you walk outside and throw a ball into the air you may notice something happens before the ball comes back down. Its rate of change slows down: its slope changes. The line drawn with a price chart isn’t unlike a line we may draw illustrating a ball travel.

trend like a ball

So, I’m not naturally attracted to “mean reversion” as most investors would define it. I point this about because when I do deal with mean reversion its only when its meaningful. When a stock, commodity, currency, or bond drops, I don’t necessarily expect it to “go back”. I find that many people do. They think because a trend drops it will snap back. They only need to be wrong about that once to lose a lot of money. You may remember some famous money managers who kept increasing their risk as losses where mounting during the 2000 – 2003 period or 2007 – 2009 period. It not stocks it was real estate.

My beliefs and strategies aren’t based on just my natural inclination, but instead based on exhaustive quantitative research, empirical observations, and real experience. I want to determine the direction of a trend and go with it for that reason, and then take note when one goes to extreme. The VIX reaching its lowest level since 2007 is such an extreme, though it could certainly stay low for longer than anyone expects.

Some people love hearing about potential reversion, so they’ll naturally be drawn to the CBOE Volatility Index. I’ll be the first to say that is not my main attraction. My natural state is more the cool high performance Porsche that is in demand rather than the ugly car no one wants, but is cheap. Though a cool Porsche at the right price is a good thing. Demand is ultimately the driver of price trends in everything, including listed options.

When we speak of the CBOE Volatility Index we are talking about a complicated index that measures the premium paid for options on the S&P 500 stocks. Robert Whaley of Vanderbilt University in Tennessee developed the CBOE Market Volatility Index for the Chicago Board Options Exchange in 1993. He had published a paper in the Journal of Derivatives with a self-explanatory title as to the intent: “Derivatives on Market Volatility: Hedging Tools Long Overdue,” which appeared in The Journal of Derivatives.

We can talk about all kinds of pricing theories and option pricing models that drive option prices and the VIX, but at the end of the day, the driver really is supply and demand.That’s what makes it my realm of expertise.

I trade volatility, and VIX derivatives specifically, for profit and for hedging So, I am not normally a writer about it, or in options sales (like a broker), but instead a fund manager who buys and sells for a profit. When I think of volatility and the VIX, I think of how I can profit from it, or how it may help me avoid loss.

That’s where I’m coming from.

The VIX is at a point we don’t see very often, so it’s a good time to take a close look.

 

The VIX, as I see it…

The CBOE Volatility Index (VIX) reached a low point last week not seen since 2007 as evidenced by the chart below.

CBOE VOLATILITY INDEX HISTORY

To see a closer view of the last period, below I included the last time the VIX was at such a low value. I show this to point out that the VIX oscillated between 9% and 12% for about 4 months before it finally spiked up to 20. Such a trend reversal (or mean reversion if you prefer) can take time. Imagine if the VIX stays this low for the next 4 months before a spike. Or, it could happen very soon. You may notice the VIX reached the level it is now at its lowest level in early 2007. If we believed these trends repeat perfectly, that absolute level would matter. Trends are more like snowflakes: no two are exactly the same. But in relative terms, the fact that today’s level is as low as the lowest point in early 2007 is meaningful if you care about the risk level in stocks and the stage of the market cycle.

CBOE VOLATILITY INDEX VIX Low levels

The best way to examine a trend is to zoom in. Start with a broader view to see the big picture, then zoom in closer and closer. When people focus too much on the short-term, they miss the forest for the trees. Below is the last time the VIX was below 12. You may notice that is does oscillate up and down in a range.

VIX BELOW 12

The level and directional trend of the VIX matters because of the next chart. You may see a trend if you look closely. The black line is the S&P 500 stock index. The black and red line is the VIX CBOE Volatility Index. You may notice the two tend to drift in opposite directions. Not necessarily on a daily basis, but overall they are “negatively correlated”. When the stock index is rising, the volatility is often falling or already at a low level. When the stock index is falling, volatility rises sharply. It isn’t a perfect opposite, but it’s there.

VIX and S&P 500 correlation and trend

If you are interested in stock trends and the trend in volatility, and specifically the current state of those cycles,  you may want to follow along in the coming days. I plan to publish a series on this topic about the VIX, as I see it. Over the last week or so I have written several ideas that I intended to publish as one large piece. Since I haven’t had time to tie it together that way, I thought I would instead publish a series.

When a trend reaches an extreme level like this, it may be useful to spend some time with it.

Stay tuned…

if you haven’t already, you may want to click on “Follow” to the right to get updates by email to follow along. This will likely be several informal notes in the coming days.

 

 

 

 

Understanding the VIX

Abstract:

In the recent weeks of market turmoil, financial news services have begun routinely reporting the level of the CBOE’s Market Volatility Index or “VIX”, for short. While this new practice is healthy in the sense that investors are asking for more information in helping to assess the state of the current economic environment and to guide through turbulent waters, it is important to understand exactly what the index means in order to fully capture its usefulness and to avoid misunderstanding and misconception. The purpose of paper is to describe the VIX and its history and purpose, and to explain how it fits within the array of indexes that help describe where the economic stands relative to other points in recent decades.

Source: Whaley, Robert E., Understanding VIX (November 6, 2008). Available at SSRN: http://ssrn.com/abstract=1296743 or http://dx.doi.org/10.2139/ssrn.1296743

To learn more, read:

Volatility ETF Strategy

Keywords: VIX, market volatitility, fear gauge, barometer of fear

The Risks of Volatility ETNs: A Recent Incident and Underlying Issues

 

ABSTRACT:

Getting volatility exposure has become easier for investors after the relatively recent introduction of volatility ETNs (exchange-traded notes) and volatility ETFs (exchange-traded funds) and some of these products have enjoyed a surge in popularity. In this paper, we use the recent crisis with TVIX – a volatility ETN – to underline important differences between ETNs and ETFs which appear to be at the source of the observed market distortion. We also emphasize an important feature of these products – that they track constant maturity VIX futures indices rather than the VIX index itself – which has an impact on the quality of the volatility exposure because of the roll-over costs and the lack of cash-and-carry arbitrage relationship.

READ the full paper: The Risks of Volatilty ETNs: A Recent Incident and Underlying Issues

 

 

Volatility Trading Strategies with VIX ETN ETF

 

Can VIX ETFs or ETNs Be Used to exploit volatility?

Exchange-traded notes (ETN) created to track the VIX index have issues with roll yield making them challenging for short term trading and outright risky for “investment”. But given their directional movement, it seems a good idea to continue to explore their potential use. (To learn more about the risks, read The Risks of Volatility ETNs: A Recent Incident and Underlying Issues.)

In “Easy Volatility Investing” Tony Cooper finds evidence that suggests traders may find volatility trading strategies applied to ETNs attractive can be useful for portfolio management. He explores the risk/reward of five volatility trading strategies including simple buy-and-hold, price momentum, futures roll yield capture, volatility risk premium capture and dynamic hedging applying the strategies to four VIX exchange-traded notes (ETN):

  •  iPath S&P 500 VIX Short-Term Futures ETN (VXX)
  • VelocityShares Daily Inverse VIX Short-Term ETN (XIV)
  • iPath S&P 500 VIX Medium-Term Futures ETN (VXZ)
  • VelocityShares Daily Inverse VIX Medium-Term ETN (ZIV)

 

 

Abstract:

For many decades the only way to invest in volatility has been through trading options, futures, or variance swaps. But in recent years a number of volatility-related exchange traded Funds (ETFs) and Exchange Traded Notes (ETNs) have been launched which make volatility trading accessible to the retail investor and fund managers without the need to access futures markets. Our objective is to devise a trading strategy using them.We document where volatility returns come from, clearing up some misconception in the process. Then we illustrate five different strategies that will appeal to different investors. Four of the strategies are simple to describe and implement. All of the strategies have had extraordinary returns with high Sharpe Ratios and low correlation to the S&P5’08 in some cases negative correlation. The returns seems to be too good to be true – like picking up $100 bills in front of a steamroller – so we have a detailed discussion on the risks and the nature of the steamroller.We illustrate how these strategies can be incorporated into existing portfolios to reduce portfolio risk especially in times of crisis. They have positive exposure to the markets during good times and negative exposure during bad times. Unfortunately they do not always provide absolute returns and while reducing net portfolio drawdowns they can themselves have significant drawdowns. Still, we suggest that a traditional 60% equities, 40% bonds portfolio should be adjusted to 55% equities, 35% bonds, and 10% volatility.
Read the full paper: Easy Volatility Investing
Source: Cooper, Tony, Easy Volatility Investing. Available at SSRN: http://ssrn.com/abstract=2255327 or http://dx.doi.org/10.2139/ssrn.2255327
Keywords: Volatility trading, Futures pricing, Volatility Risk Premium, Roll yield, Momentum

 

Can the VIX Signal Market’s Direction? An Asymmetric Dynamic Strategy

Abstract:

The article shows statistically that the VIX Implied Volatility Index is an important driver of the S&P 500 future returns. The statistical analysis is performed by means of a regression based on dummy variables in order to circumvent the difficulties posed by the lack of linearity between the variables. The results obtained are then used to construct an automated procedure that signals daily whether it is convenient to invest in the S&P 500 or to stay put. Finally, we test the quality of the signal by implementing an asymmetrical buy-and-hold strategy with 3-months horizon on the S&P 500. Our results show that the strategy outperforms the long-only strategy on the same index, thus confirming a widespread belief among traders.

Read the full paper at: Can the VIX Signal Market’s Direction? An Asymmetric Dynamic Strategy

Source: Cipollini, Alessandro Paolo Luigi and Manzini, Antonio, Can the VIX Signal Market’s Direction? An Asymmetric Dynamic Strategy (April 2007). Available at SSRN: http://ssrn.com/abstract=996384 or http://dx.doi.org/10.2139/ssrn.996384

Keywords: Implied volatility, Asset pricing forecast, Asymmetric strategies, Market’s efficiency

Quantile Regression Analysis of the Asymmetric Return-Volatility Relation

 

We use quantile regression to investigate the short-term return-volatility relation between stock index returns and changes in implied volatility index. Neither the leverage hypothesis nor the volatility feedback hypothesis effectively explains the asymmetric return-volatility relation. Instead, behavioral explanations, such as the affect and representativeness heuristics, are supported by our results, particularly in the short-term; the affect heuristic plays an important role. Moreover, in the context of an extreme volatility change distribution, the affect heuristic and time-pressure dominate. Thus, we observe strong negative and asymmetric relations between each volatility index and its corresponding stock market index. The asymmetry increases monotonically from the median quantile to the uppermost quantile (i.e., 95%); therefore, ordinary least squares (OLS) regression underestimates this relation at upper quantiles. Additionally, the VIX presents the highest asymmetric return-volatility relation, followed by the VSTOXX, VDAX, and VXN. Finally, the observed asymmetry is more pronounced with the new volatility index measure than with the old, at-the-money volatility index measure.

Read the full paper at: Quantile Regression Analysis of the Asymmetric Return-Volatility Relation

Source: Badshah, Ihsan, Quantile Regression Analysis of the Asymmetric Return-Volatility Relation (January 26, 2010). Forthcoming in the Journal of Futures Markets. Available at SSRN: http://ssrn.com/abstract=1543213 or http://dx.doi.org/10.2139/ssrn.1543213

Keywords: Asymmetric return-volatility relation, implied volatility, index options, quantile regression, volatility index

Declining (Low) Volatility = Rising (High) Complacency

When we speak of trends, we want to recognize a trend can be rising or declining, high or low. These things are subjective, because there is infinite ways to define the direction of a trend, its magnitude, speed, and absolute level. So, we can apply quantitative analysis to determine what is going on with a trend.

Below we see a quote for the CBOE Market Volatility Index (VIX). The VIX is a measure of the 30 day implied volatility of S&P 500 index options. It is a measure of how much premium options traders are paying on the 500 stocks included in the S&P 500. So, it is a measure of implied or expected volatility based on how options are priced, rather than a measure of actual historical volatility based on a past range of prices. Without going into a more detailed discussion of the many factors of VIX, I’ll add that the VIX is a fine example of an index that is clearly mean reverting. That is, the VIX oscillates between high and low ranges. Once it gets to a high level or low-level, it eventually reverts to its average. Said another way, it’s an excellent example of an index we can apply countertrend systems instead of trend following systems, because the VIX swings up and down rather than trending up or down for years.

The VIX has a long-term average of about 20 since its inception. At this moment, it is 11.82. It’s important to realize the flaw of averages here, because the VIX doesn’t actually stay around 20 – it instead averages 20 as it swings higher and lower.

VIX CBOE Market Volatility below 12

 

I used the above image from CNNMoney because it shows the rate of change in the VIX over the past 5 years on the bottom of the chart. Notice that over the past 5 years (an arbitrary time frame) market volatility as measured by VIX has declined -63.78%. To get an even better visual of the decline and price action of the VIX, below is a chart of the volatility index going back to 2001.

Do you see a trend? Do you see high and low points?

VIX Long term average high and low

We observe the current level is low by historical measures. In fact, it’s about as low at it has been. The last time the volatility index was this low was 2006 – 2007. That was just before it spiked as high as it has been during the 2007 – 2009 market crash. You can probably see what I mean by “mean reversion” and “countertrend”. When the stock market is rising, volatility gets lower and lower as investors become more complacent. Most investors actually want to get more aggressive and buy more stocks after they have already risen a lot for years, rather than realizing the higher prices go the more risky they become. We love trends, but they don’t last forever. What I think we see above is an indication that investors have become complacent, option premiums are cheap, because options traders aren’t factoring in high volatility exceptions. However, we also see that the VIX is just now down below 12.5, and area the last bull market reached in 2006 and that low volatility stayed low for over a year before it reversed sharply. Therein lies the challenge with counterrend trading: we don’t know exactly when it will reverse and trends can continue longer than we expect. And, there are meaningful shorter term oscillations of 20% or more in the VIX.

I also want to point out how actual historical volatility looks. Recall that the VIX is an index of market volatility based on how options are priced, so it implies the expected volatility over the next 30 days. When we speak of historical volatility, there are different measures to quantify the historical range prices have traded. Volatility speaks of the range of prices, so a price that averaged 100 but trades as high as 110 and low as 105 is less volatile than if it trades from 130 and 70. Below I charted the price chart of the S&P 500 since 2002. The first chart below it is ATR, which is Average True Range. ATR considers the historical high and low prices to determine the true range. A common measure is the standard deviation of historical returns. Standard deviation is charted below as STDDEV below the ATR. Below Standard Deviation is the VIX.

VIX and S&P 500 historical market volatility

Notice that the measures of volatility, both historical and implied, increase when stock prices fall and decrease when stock prices rise. Asymmetric Volatility is the phenomenon that volatility is higher in declining markets than in rising markets. You can see why I say that volatility gets lower and lower as prices move higher and higher for several years. Then, observe what happens next. Right when investors are the most complacent, the trend changes. Prices fall, volatility spikes up. They feel more sure about things after prices have been rising, so there is less indecision reflected in the range of daily trading. When investors feel more uncertain, they become indecisive, so the range of prices spread out.

Based on these empirical observations, we conclude with the title of this article.

The VIX is an unmanaged index, not a security, so it cannot be invested in directly. We can gain exposure to the VIX through derivatives futures or options. This is not a recommendation to buy or sell VIX derivatives. To determine whether or not to take a long or short position in the VIX requires significantly more analysis than just making observations about its current level and direction. For example, we would consider the term structure and implied volatility vs. historical volatility and the risk/reward of any options combinations.

 

 

 

VIX: What is the VIX?

VIX

VIX is a trademarked ticker symbol for the Chicago Board Options Exchange Market Volatility Index, a popular measure of the implied volatility of S&P 500 index options. Often referred to as the fear index or the fear gauge, it represents one measure of the market’s expectation of stock market volatility over the next 30 day period.

To learn more about VIX, read: VIX CBOE MARKET VOLATILITY INDEX and Understanding the VIX

Keywords: VIX, Implied Volatility, Market Volatility, Volatility Trading, Dynamic Hedging, Asymmetric Hedging

Fear and Greed Index

What is the Fear & Greed Index?

Investors are driven by two emotions: fear and greed. Too much fear can sink stocks well below where they should be. When investors get greedy, they can bid up stock prices way too far.

So what emotion is driving the market now? CNNMoney’s Fear & Greed index makes it clear.

They look at 7 indicators:

Stock Price Momentum: The S&P 500 (SPX) versus its 125-day moving average

Stock Price Strength: The number of stocks hitting 52-week highs and lows on the New York Stock Exchange

Stock Price Breadth: The volume of shares trading in stocks on the rise versus those declining.

Put and Call Options: The put/call ratio, which compares the trading volume of bullish call options relative to the trading volume of bearish put options

Junk Bond Demand: The spread between yields on investment grade bonds and junk bonds

Market Volatility: The VIX (VIX), which measures volatility

Safe Haven Demand: The difference in returns for stocks versus Treasuries

For each indicator, CNNMoney’s Fear & Greed index looks at how far they’ve veered from their average relative to how far they normally veer. They look at each on a scale from 0 – 100. The higher the reading, the greedier investors are being, and 50 is neutral.

Then they put all the indicators together – equally weighted – for a final index reading.

CNNMoney maintains the index. You can follow the index at this link: http://money.cnn.com/data/fear-and-greed/

When the S&P 500 (SPX) plummeted to a three-year low on Sept. 17, 2008 – the height of the financial crisis — the Fear and Greed index sank to 12. The index gained some ground to 28 before stocks finally bottomed out on March 9, 2009 and the latest bull market began.

Most recently, in the first quarter of 2012, stocks staged their best run in decades, and the index showed pure greed.

Source: CNNMoney’s Fear & Greed index

Is this the Inflection Point for Stocks?

As if the election result wasn’t enough, the U.S. stock market has surprised most people by trending up since last November.

But, it has been stalling since March. The S&P 500 drifted down about -3% into March and April.

The stock market seems to be at an inflection point now.

Understanding the market state is an examination of the weight of the evidence.

The weight of the evidence seems to suggest defense.

My first indicator is always the actual price trend itself. If we want to know what is going on, there is no better observation than the actual price trend. The price action tells us what force is in control: supply or demand. And, we can see the potential for the inflection point – when the direction is changing. In the chart below, I highlight a recent point of “resistance”. I call it resistance because the stock index hasn’t broken above the March high and is instead drifting sideways.

average age of bull market top

Investors sometime assume a prior price high will automatically become “resistance” just because it’s the price range they expect to see the price trend stall. Resistance is the price level where selling is expected to be strong enough to prevent the price from rising further. We can see that recently in the chart. As the price advances towards the prior peak, supply may overcome demand and prevent the price from rising above resistance. For example, it may be driven by investors who wished they had sold near the prior peak and had to wait as the price recovered again. They anchor to that prior high. Once it gets back to the prior peak, they exit. Prior highs don’t always become “resistance” as expected. Sometimes demand is strong enough to break through and keep trending up. At this point, we see there has been some resistance at the prior high. I highlighted it in yellow in the chart above. So, we shouldn’t be surprised to see the price decline if this resistance holds for a while. Or, it could be an inflection point.

The S&P 500 stock index is mainly large companies. Smaller companies tend to lead larger companies. Their price trends move in a wider range and they sometimes move faster, so they get to a point sooner. That’s why we say small company stocks “lead” large company stocks. In that case, I highlight below that the small company stock index, the S&P 600 Small Cap ETF, reached its prior, but found resistance and reversed down. The soldiers may lead the way for the Generals.

Small Cap

It seems that the stock index is stalling at a time when investors are complacent. When investors are complacent or overly optimistic an inflection point is more likely. The CBOE Volatility Index® (VIX® Index)  is very low. The CBOE Volatility Index® (VIX® Index®) is a key measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices. The VIX® historically trends between a long-term range. When the VIX® gets to an extreme, it becomes more likely to eventually reverse. In the chart below I show the price level of the VIX® since its inception in 1993. We can see its long-term average is around 20. I highlighted in red its low range is around 12 and it has historically spiked as high as 25 or 60. This means the traders of options are expecting lower volatility in the weeks ahead at a time when other things seem to suggest otherwise.

As I continue sharing some observations, I’m going to get farther away from my main decision maker which is the directional price trend, but you’ll see how these indicators help to quantify the state of the trend and the potential for an inflection point. As we keep going, keep in mind that indicators are a derivative of the price at best or a derivate of something unrelated to the directional price trend. In the case of the VIX® Index index above, it’s a measure of options (a derivative) on the stocks in the S&P 500. When we start looking at things like economic growth and valuations we are necessarily looking at things that are a derivative of price, but not as absolute as the price trend itself. The direction of the price trend is the arbiter.

Another signal of an inflection point is breadth. That is, what percent of stocks are rising or falling. Since I have mentioned the S&P 500 stock index, I’ll show the S&P 500 Bullish Percent Index below. The Bullish Percent is a breadth indicator based on the number of stocks on Point & Figure buy signals. Developed by Abe Cohen in the mid-1950s, the Bullish Percent Index was originally applied to NYSE stocks. Cohen was the first editor of ChartCraft, which later became Investors Intelligence. BP signals were further refined by Earl Blumenthal in the mid 70’s and Mike Burke in the early 80’s. The S&P 500 Bullish Percent shows a composite of the 500 stocks in the S&P 500 index that are in a positive trend. The S&P 500 Bullish Percent recently reversed to a column of O’s from a high point of 80, which means about 80% of the S&P 500 stocks were in a positive trend and about 8% of them are now in a negative trend. In addition to the direction, the level is important because we consider the level above 70% or 80% to be a higher risk (red zone) and the levels below 30% to be lower risk (green zone). So, more and more stocks within the index are starting to decline. This weak “breadth” or participation could be a signal of a change in trend.

Bullish Percent

I’m not necessarily a big user of economic indicators. I believe the stock indexes are the leading indicator for the economy, so that’s my guide. However, I have a strong sense of situational awareness so I like to understand what in the world is going on. The total return of stocks is a function of three things: earnings growth + dividend yield + P/E ratio expansion or contraction. Since earnings growth has made up nearly 5% of the historical total return of the S&P 500 since 1926, it does matter in the big picture in regard to expected return. Today, we observe the headline in the Wall Street Journal:

GDP Slows to Weakest Growth in Three Years

The U.S. economy’s output grew at the slowest pace in three years during the first quarter, underscoring the challenges facing the Trump administration as it seeks to rev up growth.

The New York Times says:

G.D.P. Report Shows U.S. Economy Off to Slow Start in 2017

■ The economy barely grew, expanding at an annual rate of only 0.7 percent.

■ The growth was a sharp decline from the 2.1 percent annual rate recorded in the final quarter of last year. It was the weakest quarterly showing in three years.

■ Consumption, the component reflecting individual spending, rose by only 0.3 percent, well below the 3.5 percent rate in the previous quarter.

The Takeaway

The first-quarter performance upset expectations for a Trump bump at the start of 2017.

If you want an economic catalyst for why prices could stall or reverse down, there you go. You see, earnings growth of stocks is part of GDP. GDP is the sales of all U.S. companies, private and public. The earnings growth of the S&P 500 is the earnings of those 500 companies. In other words, GDP of the economy is highly connected to EPS of an index of 500 stocks.

This recent stall in the price trend and economic growth along with a dash of complacency comes at a time when stocks are “significantly overvalued”, according to my friend Ed Easterling at Crestmont Research:

“In the first quarter the stock market surged 5.5%, well more than underlying economic growth. As a result, normalized P/E increased to 29.4—significantly above the level justified by low inflation and low interest rates. The current status remains “significantly overvalued.” The level of volatility plunged over the past quarter and is now in the lowest 4% of all periods since 1950. The trend in reported earnings for the S&P 500 Index reflects a repeating pattern of overly-optimistic analysts’ forecasts. Earnings and volatility should be watched closely and investors should heighten their sensitivity to the risks confronting an increasingly vulnerable market.”

Oh, and one more thing: Monday will be May. I’m not a huge fan of using seasonality as an indicator to enter or exit the stock market, but there is some tendency for certain periods to gain or lose value historically. For example, a common seasonality is “Sell in May and go away”. Depending on the historical time frame you look and which index, some periods show a “summer slump”. One theory is many investors and traders go on vacation in the summer, so volume is light. They return after the summer and take more action.

So, maybe this will be a good time to sell in May and go away. Not because it’s May, but instead because the weight of the evidence suggests this could be an inflection point.

We’ll see.

You want to be fearful when others are greedy?

“You want to be greedy when others are fearful. You want to be fearful when others are greedy. It’s that simple.… ” – Warren Buffett

Investors are emotional and we can profit from it.

Though investors are emotional, they can also manage their emotions to feel the right feeling at the right time.

Market trends are both the result of investor behavior and driven by it. Anyone who watches “the market” has had feelings of fear and greed at some point. Those who “watch it closely” feel it often.

  • Fear: I am losing money! Is it ever going to stop?
  • Worried: How much more money will I lose?
  • Defeated: I’ve lost so much money I don’t know what I’m going to do.
  • Hope: I hope I make money this time. I hope it keeps going up!
  • Greed: I’m up X%! Up! this, Up! that. I’m up!
  • Euphoric: I’m going to tell everyone how much I’m UP! Up, up, and away!

All of these feelings and reactions drive directional price trends. Emotions also determine investor’s results. Investor behavior determines investor’s results as much as their investment program or the market.

fear-and-greed-index-explaination-cnn

Investor sentiment just reached “Extreme Greed” again. Investor sentiment tends to swing from “Fear” to “Greed” a few times a year, mostly reacting to the price trend. That is, we don’t see the majority of investors getting fearful when others are greedy. Instead, we see them get fearful after prices have fallen and they’ve lost some value. We don’t see investors getting greedy after prices fall, we instead see them get greedy after prices have already gained and they are “up”.

Being “up” in a position doesn’t mean anything if it’s “down” in the next period.

Being “up” in a position is an open profit until it’s closed.

An open profit is just the markets money until it’s realized by selling it.

A realized gain is a profit that has been taken by selling.

The Fear & Greed Index I used above is one that is simple to follow for anyone who wants to give themselves a reality check.

If you find yourself feeling euphoric and talking about how great “the market” or your investments are “doing”, this measure is likely dialed to the right for “Extreme Greed”.

If you find yourself fearful of more losses after losses you may be taking too much risk, but it could also be near a turning point. One the one hand, you don’t want to reach your uncle point and tap-out. So, you predefine your tolerance for loss and match that with an investment program that includes risk management and drawdown control.

You want to avoid doing the wrong things at the wrong time- like the quote said.

Although the Fear & Greed Index equally weights seven different sentiment indicators, the most prominent of them is the CBOE Volatility Index® (VIX® Index®), which is a key measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices. When the VIX gets really low like it is now, it suggests that expectations for near-term volatility is very low.  I say “really low” because, as you can see, its current level of 10.74 is about as low as it’s gotten since introduction in 1993. That’s a contrary indicator because it’s at such an extreme. It seems the market is getting complacent and any surprise will shock them.

vix-cboe-volatility-index

What does this mean?

We shouldn’t be surprised to see the recent upward price trend reverse down some, at least temporarily.

And, those who apply the simple sounding strategy of “You want to be greedy when others are fearful. You want to be fearful when others are greedy.” may start to take some profits and preparing to take advantage of, or avoid, a later decline.

It doesn’t mean it will be a large decline, though it could be. For example, the last time I pointed out “Investor Optimism is Reaching Extreme” was December 9th of last year. As you can see below, the stock index dropped only about -2% over the next two weeks. That’s a small drop. Based on history, we expect to see swings of stock index prices of -5% to -10% two or three times a year. When I see such overbought conditions as I see now, I expect that level of normal decline.

decline-since-fear-and-greed-index

The upward trend in U.S. stocks has mostly been uninterrupted since last November. You can probably see how this just adds to the weight of the evidence that we shouldn’t be surprised to see a “normal” drop at some point. As a tactical trader, I prefer to avoid large declines when I can and take advantage of them.

We’ll see how it unfolds this time…

Ps. This is not investment advice and I don’t publish such observations for every swing I see.

Investor Optimism Seems Excessive Again

When someone asks me why I hold so much cash or against a market decline, it always corresponds to extreme optimism readings in the most basic investor sentiment indicators. Investors have poor long-term results because they feel the wrong feeling at the wrong time. They feel optimistic after price gains just before they decline. They fear more losses after they hold on to losing trends, and their losses get large.

After the stock market declined and then reversed back up to make headlines investor sentiment has reached the level of “Extreme Greed” once again. I don’t use the CNN Fear & Greed Index as a trading signal as my systems focus on other things, but I think it’s a publically available source that is useful to help investors avoid feeling the wrong feeling at the wrong time.  For example, the CNN Fear & Greed Index uses eight indicators of investor sentiment to determine Fear or Greed. The reading oscillates between Extreme Fear, Fear, Neutral, Greed, and Extreme Greed. If you feel optimistic about future prices and the reading is at Extreme Greed, you are probably wrong. If you feel fearful about future prices and the reading is at Extreme Fear, you are probably wrong. You see, most investors feel the wrong feeling at the wrong time.

As you see below, it has reached the “Extreme Greed” point, and that often signals high risk and eventually precedes at least a short-term trend reversal.

CNN Fear Greed Index

Source: CNN Fear & Greed Index

 

Below is a chart of the past 3 or so years of the Fear & Greed reading. As you see, the levels of fear and greed do indeed oscillate from one extreme to the other over time. I think we observe these readings indicate the wrong feeling at the wrong time.

Fear and Greed over time investor sentiment

Source: CNN Fear & Greed Index

The most obvious extreme level is the extremely low level of expected future volatility. Maybe they are right, but when the VIX Volatility Index reaches such as extreme low it often signals at least a short-term stock market peak that reverses down.

VIX Volatility Index.jpg

I like directional trends, but I also believe they sometimes reach extremes at a point and then reverse.

We’ll see how this one unfolds in the weeks and months ahead…

You can probably see why it’s prudent to actively manage risk and hedge at certain extremes.

To learn more, contact us.

Global Markets Year to Date

This is a quick year to date observation of some global market trends. First, we start with the popular U.S. stock market indexes. The Dow Jones Industrial Average is down -9.6% YTD. S&P 500 is down about -7%. A simple line chart shows a visual representation of the trend and the path it took to get there.

stock index return year to date

Source of Ycharts in this article: Shell Capital Management, LLC drawn with http://www.ycharts.com

I like to look at the asymmetry ratio of the trend, so I observe both the upside total return and the downside drawdown. Below is a chart of the % off the highest price these indexes reached to define the drawdown from its prior peak. This is how much they’ve declined from their highest point so far this year. The Dow Jones Industrial Average is down -12.8% from it’s high, the S&P 500 is down 10.8%.

stock index drawdown chart

Below are the sectors year to date. Healthcare remains the leader and the only one positive at this point.

sectors year to date

Source:Shell Capital Management, LLC  drawn with  http://finviz.com

Looking at a few more broad based alternatives, below is the iShares S&P GSCI Commodity-Indexed Trust (GSG: blue) which seek to track the results of a fully collateralized investment in futures contracts on an index composed of a diversified group of commodities futures. The red line is Gold (GLD) and the orange line is the iShares Core U.S. Aggregate Bond ETF seeks to track the investment results of an index composed of the total U.S. investment-grade bond market. Bonds are flat (including interest), gold is down -3%, and the commodity index is down -24%.

bonds commodities year to date

We are beginning to observe that a fixed asset allocation to these markets, no matter how diversified, may be very negative this year.

What about International stocks? Below we see some material divergence so far between developed International markets (EFA) and emerging markets (EEM). The iShares MSCI EAFE (EFA) seeks to track the investment results of an index composed of large- and mid-capitalization developed market equities, excluding the U.S. and Canada. Those countries index is down -2.9%. The iShares MSCI Emerging Markets (EEM) seeks to track the investment results of an index composed of large- and mid-capitalization emerging market equities. It is down -18.6%.

international emerging markets year to date

What about global stock markets? A few are positive year to date, most are very negative.

global stock markets year to data

Source:Shell Capital Management, LLC  drawn with  http://finviz.com

What about individual commodities, interest rates, and volatility? The VIX was low most of the year, but now that markets have declined the implied volatility of stocks has spiked.

world markets year to date

Source:Shell Capital Management, LLC  drawn with  http://finviz.com

I believe world markets require active risk management and defining directional trends. For me, that means predefining my risk in all of them, not just a fixed allocation.

Flash Crash May 6, 2010

Flash Crash Findings High Frequency Trading Flash Boys

The following explanation of the “Flash Crash” on May 6, 2010  is from “FINDINGS REGARDING THE MARKET EVENTS OF MAY 6, 2010″.

On May 6, 2010, the prices of many U.S.-based equity products experienced an extraordinarily rapid decline and recovery. That afternoon, major equity indices in both the futures and securities markets, each already down over 4% from their prior-day close, suddenly plummeted a further 5-6% in a matter of minutes before rebounding almost as quickly.

Many of the almost 8,000 individual equity securities and exchange traded funds (“ETFs”) traded that day suffered similar price declines and reversals within a short period of time, falling 5%, 10% or even 15% before recovering most, if not all, of their losses. However, some equities experienced even more severe price moves, both up and down. Over 20,000 trades across more than 300 securities were executed at prices more than 60% away from their values just moments before. Moreover, many of these trades were executed at prices of a penny or less, or as high as $100,000, before prices of those securities returned to their “pre-crash” levels.

By the end of the day, major futures and equities indices “recovered” to close at losses of about 3% from the prior day.

WHAT HAPPENED?

May 6 started as an unusually turbulent day for the markets. As discussed in more detail in the Preliminary Report, trading in the U.S opened to unsettling political and economic news from overseas concerning the European debt crisis. As a result, premiums rose for buying protection against default by the Greek government on their sovereign debt. At about 1 p.m., the Euro began a sharp decline against both the U.S Dollar and Japanese Yen.

Around 1:00 p.m., broadly negative market sentiment was already affecting an increase in the price volatility of some individual securities. At that time, the number of volatility pauses, also known as Liquidity Replenishment Points (“LRPs”), triggered on the New York Stock Exchange (“NYSE”) in individual equities listed and traded on that exchange began to substantially increase above average levels.

By 2:30 p.m., the S&P 500 volatility index (“VIX”) was up 22.5 percent from the opening level, yields of ten-year Treasuries fell as investors engaged in a “flight to quality,” and selling pressure had pushed the Dow Jones Industrial Average (“DJIA”) down about 2.5%.

Furthermore, buy-side liquidity3 in the E-Mini S&P 500 futures contracts (the “E-Mini”), as well as the S&P 500 SPDR exchange traded fund (“SPY”), the two most active stock index instruments traded in electronic futures and equity markets, had fallen from the early-morning level of nearly $6 billion dollars to $2.65 billion (representing a 55% decline) for the E-Mini and from the early-morning level of about $275 million to $220 million (a 20% decline) for SPY.4 Some individual stocks also suffered from a decline their liquidity.
At 2:32 p.m., against this backdrop of unusually high volatility and thinning liquidity, a large fundamental5 trader (a mutual fund complex) initiated a sell program to sell a total of 75,000 E-Mini contracts (valued at approximately $4.1 billion) as a hedge to an existing equity position.
Generally, a customer has a number of alternatives as to how to execute a large trade. First, a customer may choose to engage an intermediary, who would, in turn, execute a block trade or manage the position. Second, a customer may choose to manually enter orders into the market. Third, a customer can execute a trade via an automated execution algorithm, which can meet the customer’s needs by taking price, time or volume into consideration. Effectively, a customer must make a choice as to how much human judgment is involved while executing a trade.
This large fundamental trader chose to execute this sell program via an automated execution algorithm (“Sell Algorithm”) that was programmed to feed orders into the June 2010 E-Mini market to target an execution rate set to 9% of the trading volume calculated over the previous minute, but without regard to price or time.
The execution of this sell program resulted in the largest net change in daily position of any trader in the E-Mini since the beginning of the year (from January 1, 2010 through May 6, 2010). Only two single-day sell programs of equal or larger size – one of which was by the same large fundamental trader – were executed in the E-Mini in the 12 months prior to May 6. When executing the previous sell program, this large fundamental trader utilized a combination of manual trading entered over the course of a day and several automated execution algorithms which took into account price, time, and volume. On that occasion it took more than 5 hours for this large trader to execute the first 75,000 contracts of a large sell program.
However, on May 6, when markets were already under stress, the Sell Algorithm chosen by the large trader to only target trading volume, and neither price nor time, executed the sell program extremely rapidly in just 20 minutes. 7additional 1.7% in just these 15 seconds, to reach its intraday low of 1056. This sudden decline in both price and liquidity may be symptomatic of the notion that prices were moving so fast, fundamental buyers and cross-market arbitrageurs were either unable or unwilling to supply enough buy-side liquidity.
In the four-and-one-half minutes from 2:41 p.m. through 2:45:27 p.m., prices of the E-Mini had fallen by more than 5% and prices of SPY suffered a decline of over 6%. According to interviews with cross-market trading firms, at this time they were purchasing the E-Mini and selling either SPY, baskets of individual securities, or other index products.
By 2:45:28 there were less than 1,050 contracts of buy-side resting orders in the E-Mini, representing less than 1% of buy-side market depth observed at the beginning of the day. At the same time, buy-side resting orders in SPY fell to about 600,000 shares (equivalent to 1,200 E-Mini contracts) representing approximately 25% of its depth at the beginning of the day.
Between 2:32 p.m. and 2:45 p.m., as prices of the E-Mini rapidly declined, the Sell Algorithm sold about 35,000 E-Mini contracts (valued at approximately $1.9 billion) of the 75,000 intended. During the same time, all fundamental sellers combined sold more than 80,000 contracts net, while all fundamental buyers bought only about 50,000 contracts net, for a net fundamental imbalance of 30,000 contracts. This level of net selling by fundamental sellers is about 15 times larger compared to the same 13-minute interval during the previous three days, while this level of net buying by the fundamental buyers is about 10 times larger compared to the same time period during the previous three days.
At 2:45:28 p.m., trading on the E-Mini was paused for five seconds when the Chicago Mercantile Exchange (“CME”) Stop Logic Functionality was triggered in order to prevent a cascade of further price declines. In that short period of time, sell-side pressure in the E-Mini was partly alleviated and buy-side interest increased. When trading resumed at 2:45:33 p.m., prices stabilized and shortly thereafter, the E-Mini began to recover, followed by the SPY.
The Sell Algorithm continued to execute the sell program until about 2:51 p.m. as the prices were rapidly rising in both the E-Mini and SPY.

To learn more, read: “FINDINGS REGARDING THE MARKET EVENTS OF MAY 6, 2010″.

Global Market Trends Mid Year 2014

I’m not one to put much emphasis on judging trends across arbitrary time frames like “mid year” or a specific calendar year, but it’s still interesting to see how global trends are playing out relative to how people perceive they are. At the end of last year the Dow Jones Industrial Average (DIA) was all the talk since it was the biggest gainer. So far in 2014 that DIA has gained only 2.54%. So, we could say that, though its range of motion and swings (volatility) has calmed down lately. Over the past 6 months the Dow stocks have lost their momentum. Those who only listen to financial news about stocks may be surprised to hear the 30 year U.S. Treasuries as measured by TLT have been the biggest gainer this year at 12%. Gold (GLD) and Emerging Markets (EEM) have had the largest range of swings. The broad-based bond index (AGG), Commodities (GSG), and Developed Countries (EFA) have trended similar to the Dow. I included $VIX, the CBOE Volatility Index to point out several observations. Notice how it has generally trended down and is down -15% over the first half of the year, you may also notice how much more it spikes up and down. That is, volatility is volatile.

Global market trend returns mid year 2014

Source: http://www.stockcharts.com

It’s important to understand that no intelligent person investors all their capital in stocks or in U.S. Treasuries or in Gold. Instead, they either allocate to many markets or rotate between them. The trouble with allocation to markets is they sometimes all go down at the same time, so diversification through just allocation may fail when you want it the most. That is why we rotate, instead of allocate, hoping to capture some of the good, and avoid most of the bad. No market trends up all the time and no strategy trends perfectly all the time, but the overall risk / reward profile is what matters. If someone can handle 50% declines and willing to wait 5 or more years to reach prior values, maybe they could invest all their money in stocks. We could say the same for commodities, real estate, and bonds. That is why we rotate, instead of allocate.

Have a great 4th of July!

 

It’s official: extreme greed is driving the stock market

In Is the VIX and indication of fear and complacency? I pointed out a few reasons I believe a low VIX level can indeed be a signal of greed and complacency and a high VIX level is a measure of fear. It’s very simple: fear and greed are reflected in the price of options. When there is a strong demand for protection, the prices goes up. When there is little demand for protection, the price goes down. The recent low levels of VIX suggest a lack of fear or desire for protection from falling prices or rising vol.

I also said that the VIX levels often correspond with other sentiment levels. I have used the Fear and Greed Index before to explain how investors oscillate between the fear of missing out and the fear of losing money. After prices rise, we observe they get more greedy. For example, if they didn’t have strong exposure they may feel regret and fear missing out. After prices fall, they are afraid of losing more money. This Fear and Greed Index is published by CNN Money and is publicly available, making it useful for this purpose to illustrate how behavior drives trends. As you can see below, the current level is “Extreme Greed”, so that is the emotion driving stocks right now.

Greed index correlates with low vix

Source: CNNMoney’s Fear & Greed index

This Fear and Greed Index includes 7 different sentiment indicators. Market volatility as measured by VIX is one of them. In observing sentiment indicators like this, we see them oscillating between extreme greed and extreme fear over time. It spends a lot of time in the middle, too, but trends often reverse when it gets to extremes. When it reaches Extreme Greed, it eventually reverses down after prices peak out and reverse down. When it gets to an extreme greed level like it is now, we eventually see something come along and surprise them. I think it’s because investors become complacent and the stunned. Change is most alarming when it isn’t expected. When stocks fall, it will move toward fear as they fear losing more money. However, these measures can certainly stay extreme for longer than you think. That is the challenge to countertrend systems and thinking: trends do tend to persist, making it more difficult to bet against the wind. But when we see levels like this, we shouldn’t be so surprised when it changes direction.

 

 

Investors are Complacent

Implied volatility, the amount of “insurance premium” implied by the price of options, continues to suggest that investors are becoming very complacent. When the VIX is high or rising, it says the market expects the S&P to move up or down more. When the VIX is low or declining, it says the market expects the S&P 500 will not move up or down as much in the future. That is, the “insurance premium” priced into options on the S&P 500 stocks is low. That isn’t necessarily directional – it is an indication of the expected range, not necessarily direction. However, what I know about directional price trends is that after a price has been trending directionally for some time, as the S&P 500 stock index has, investors become more and more complacent as they expect that trend to continue. The mind naturally wants to extrapolate the recent past into the future and it keeps doing it until it changes. When we see that in the stock market, it usually occurs as a directional trend is peaking. Investors are caught off guard as they expected a tight range. If the range in prices widens, they probably widen even more because they are – and it wasn’t expected. Interestingly, people actually expect inertia and that is one of the very reasons momentum persists as it does. Yet, momentum may eventually move prices to a point (up or down) that it may move too far and actually reverse the other way.

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If we believe the market is right, we would believe the current level accurately reflects the correct expecation for volatility the next 30 days. That is, we would expect today’s implied volatility of about 12 – 13% will match the actual historical volatility 30 days from now. In other words, 30 days from now the historical (backward looking) volatility is match the current implied volatility of 12.6%. If we believe the current volatility implied by option premiums is inaccurate, then we have a position trade opportunity. For example, we may believe that volatility gets to extremes, high or low, and then reverses. That belief may be based on empirical observation and quantitatively studying the historical data to determine that volatility is mean reverting – it may oscillate in a range but also swing from between one extreme to another. If we believe that volatility may reach extremes and then reverse, we may believe the market’s implied volatility is inaccurate at times and aim to exploit it through counter-trend systems. For example, in my world, volatility may oscillate in a range much of the time much like other markets, except it doesn’t necessarily have a bias up or down like stocks. There are times when I want to be short volatility (earning premium from selling insurance) and long volatility (paying premium to buy insurance). I may even do both at the same time, but across different time frames.

The point is, the market’s expectation about the future may be right most of the time and accurately reflect today what will be later. But, what if it’s wrong? If we identify periods when it may be more likely wrong, such as become too complacent, then it sets up a position opportunity to take advantage of an eventual reversal.

Of course, if you believe the market is always priced accurately, then you would never take an option position at all. You would instead believe that options are priced right and if you believe they are, you believe there is no advantage in being long or short them. I believe the market may have it right most of the time, but at points it doesn’t, so convergence trades applying complex trade structures with options to exploit the positive asymmetry between the probability and payoff offers the potential for an edge with positive expectation.