iBankCoin
Joined Jan 1, 1970
204 Blog Posts

Extendo VIX

It’s no secret volatility has sat at extraordinary levels for quite some time now. But is this unique? Not quite yet, according a recent presentation from the man that invented the VIX, Robert Whaley, now a professor at Vanderbilt.

An important way of judging market anxiety is to examine the persistence with which VIX remains above certain extraordinary levels. From Table 1 (in the presentation), we know that the chance of observing a VIX level above 34.22 is 5%. Suppose we re-examine the VIX history to count the number of consecutive days that VIX has remained above a level of 34.22. Four periods last more than 20 days can be identified: October 16 through December 22, 1987 (45 days), August 28 through October 31, 2002 (46 days), September 26 through October 31, 2008 (26 days so far), and January 8 through February 8, 1988 (22 days). So, yes, we are experiencing abnormal behavior, but, no, it is not unprecedented. We just tend to forget.

Now we’re something like 12 more days into it. And not likely close to going below 34.22 any time soon. So 3 weeks after this presentation, it does look like we’ll set records for the amount of time we spend at extremes.

If you look at the VIX futures, it could be a while longer. March trades at about a 46, and April at a 42. Doesn’t mean we will stay elevated out that long, I mean it’s a 50/50 bet and maybe the “under” wins. And if the under doesn’t win, those numbers just represent snapshots and say nothing of whether the VIX dips into the 30’s between now and then.

What it does all suggest is that even though the The Chattering Pundit Class was way early calling these times unprecendented, looks like they may ultimately be correct.

And it all makes sense in a way. We’ve experienced a crash similar to 1987, it’s just played out over such an extended time frame. So it stands to follow that Fear will linger a bit longer.

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Volatility Here to Stay?

Hey, if you like your volatility for the longer term, and you think it’s about 1930 right now on the Crash Clock, you may be in luck. MarketSci Blog looks at some charts, and sees this (hat tip Abnormal).

A few non-surprises here. (1) Volatility from 2004 through most of 2007 was close to historical lows. (2) Current volatility is at levels only seen a few times in market’s history: the late 1920’s, various points in the 1930’s, and 1987. And (3) the market exceeds two standard deviations far more often than it would if it followed a random walk (an assumption of modern finance that is fatally flawed).

The reason that this chart caught my eye was how sustained volatility was in 1920’s and 30’s. We went years and years experiencing the kind of gut wrenching gyrations we’re seeing now. I know it’s dangerous to compare this market to that one, but if we allow history to be our guide here, this ride could be a long way from being over.

But here’s something modestly counterintuitive amid the options volatility boom. Volume has declined, as per WSJ’s Marketbeat.

Trading in options has been declining as a result of the high volatility. For the month of November through Tuesday, about 11.4 million contracts changed hands daily, compared with the 2008 average through Tuesday of 14.6 million contracts, according to the Options Clearing Corp.

Alhough maybe it makes sense. Higher volatility means higher prices for everything, and fewer contracts needed to cover a specific bet or play.

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Myth Buster?

So, remember that urban legend that states As Goes the Market The Thursday Before Expiration, so it goes in reverse into the actual Expiration?

Well, we had a big up day yesterday, which surely means we will get plowed from here on in. At least that’s what our forefathers told us.

But also, Rob Hanna and has Quantifiable Edges database took a gander at the issue back in April, and found pretty much no “there” there.

Buying (shorting) at the close on Thursday before expirations week if the market was down (up) and selling (covering) the Friday of expirations would have netted the following results since July 1978:

Trades – 354
Winners – 171
Losers – 182 (1 breakeven)
Average trade – -0.08%

Now the market generally sux, so it won’t shock anyone if we head back south sometime soon. But it’s pretty safe to say it will have nothing to do with some sort of expiration rule.

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VIXed Out

CXO Advisory studies the relationship between the VIX and future stock market returns.

Experts and pundits often cite a very high (low) Chicago Board Options Exchange (CBOE) Volatility Index (VIX) as an indication of investor panic (complacency), and therefore of a pending U.S. stock market advance (decline). Is this conventional wisdom regarding VIX as a market reversal sentiment indicator accurate? To check, we relate the level of VIX to future stock market returns (using the S&P 500 index to represent the overall stock market) over horizons of 10, 21, 63 and 252 trading days. Because VIX tends to “stick” in high and low regimes over extended periods, we also relate the level of VIX relative to its 63-trading day moving average to future stock market returns.

That “regime” concept gets it spot on. We lived in a high VIX world in the late 90’s through about 2001, followed by a low VIX world until about February 2007. And right now we’re back to high again, such that if we see 40 again, it’s almost tantamount to about a 20 or 15 a few years ago. So if you’re going to use the VIX, it would seem that you can throw absolute numbers into the hopper.

So what do they find? Well, first, how about an absolute VIX.

Over the entire sample period, the Pearson correlation between VIX and S&P 500 index returns over the next 10 (21 / 63 / 252) trading days is 0.02 (0.04 / 0.09 / -0.03). These very low correlations suggest no relationship between the level of VIX and future stock market returns.

I’m sure Dennis Kneale will disagree.

What about “relative” VIX? They compare it to it’s rolling 63 day MA and find.

The chart suggests that a relatively low VIX is slightly bullish across all return horizons. It also suggest that a relatively high VIX is somewhat bearish over the near term and bullish for the intermediate and long terms.

OK, we’re getting somewhere. But almost exactly opposite of what we think. It’s almost as if……the VIX is a coincidental indicator that kind of confirms something we may already know.

But wait, there’s even less than meets the eye. As CXO accurately points out, high and low readings tend to cluster and reaffirm themselves.

So they account for that too, and find.

Results are mixed. Over the short and intermediate terms, stock market returns after extreme VIX conditions are mostly close to the norm. Over the long term, returns after all the relatively extreme VIX conditions underperform the norm. However, subsample sizes are small, especially for long-term returns, so these conclusions are not reliable. Just a few new instances could substantially alter average returns.

Moreover, there are not enough trading opportunities to make a strategy based solely on the selected thresholds for VIX signals interesting.

Bottom line is it all kind of makes sense. I find the most value in the VIX from divergences to the expectation. Is it seeing something we don’t? Is it underpricing risk, as it did all through October when realized volatility soared ahead of options volatility? Is it too high or too low relative to actual stock volatility?

It’s subjective, but so be it, there’s no magic bullet here. Right now I subjectively find volatility close to correct. Realized volatility has tamped down a bit, we just drift now. But the market’s incredibly ugly, and you’ll never get a big options selloff when that’s going on.

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Veteran’s Day VIX Blahs

So it seems like only yesterday they were manipulating the SPX options to gin up the VIX settlement price for October.

Well guess what, we’re only a week until November expiration. As I discovered recently, there’s reason behind the seeming randomness of the VIX options expiration; it’s 30 days ahead of the next SPX expiration.

So what’s going on? Jamie here says lots of buyers in the OTM Nov calls, specifically the 70’s, 75’s and 80’s. Insurance against further market dippage, or pure speculation? Time will tell.

My personal opinion right now, subject to change without any particular reason, is that options (stock and ETF options, not VIX ones) are a better sale now at VIX 60ish than they were at higher volatility levels. We’re in a bit of a trading range for now, and actual stock volatility has tamped down from the recent extremes.

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Tripling Out

If only I could leverage the market, TO THE EXTREME!!!!!!

Oh wait, I can now. Hat tip Abnormal Returns.

Market-timers rejoice! Today, Boston-based Direxion officially launched the first group of exchange-traded funds that offer triple leverage, or 300% exposure to market indexes to make bullish or bearish bets. With excessive financial leverage at the heart of the current credit crises, the timing of this launch may surprise some. Over the past several months market participants have experienced unprecedented levels of volatility. With a dynamic regulatory environment, blitzes of weak economic data, credit markets that have yet to fully thaw, and uncertainty surrounding the new administration, it seems as though volatility may remain for some time. For investors looking to magnify market returns with these aggressive products, we can offer some simple advice: Hold on to your hats.

These sound like an awesome idea. Let’s say we have an index that’s 100, and up a pedestrian 3% today. The Triple Latte Inverses will go down to 91. Now on Day 2, said index goes back to 100, unch. in two days. The Triple Latte Inverse only gets back to 98.95. The same round trip in the underlying leaves the Triple Ultra’s at 99.47.

If you’re lucky enough to catch a trend move, you’ll love the Triples. If you miss, or are even mediocre like this trade, look out.

But hey, why stop here. If man can create a TV screen that includes the collective wisdom or 8 Financial Pundits at once, surely man can create Octo-Leverage. And Octo-Inverse-Leverage.

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