Global Market Comments
April 23, 2018
Fiat Lux
Featured Trade:
(THE MARKET OUTLOOK FOR THE WEEK AHEAD, or HERE COMES THE FOUR HORSEMEN OF THE APOCALYPSE),
(SPY), (GOOGL), (TLT), (GLD), (AAPL), (VIX), (VXX), (C), (JPM),
(HOW TO AVOID PONZI SCHEMES),
(TESTIMONIAL)
Have you liked 2018 so far?
Good.
Because if you are an index player, you get to do it all over again. For the major stock indexes are now unchanged on the year. In effect, it is January 1 once more.
Unless of course you are a follower of the Mad Hedge Fund Trader. In that case, you are up an eye-popping 19.75% so far in 2018. But more on that later.
Last week we caught the first glimpse in this cycle of the investment Four Housemen of the Apocalypse. Interest rates are rising, the yield on the 10-year Treasury bond (TLT) reaching a four-year high at 2.96%. When we hit 3.00%, expect all hell to break loose.
The economic data is rolling over bit by bit, although it is more like a death by a thousand cuts than a major swoon. The heavy hand of major tariff increases for steel and aluminum is making itself felt. Chinese investment in the US is falling like a rock.
The duty on newsprint imports from Canada is about to put what's left of the newspaper business out of business. Gee, how did this industry get targeted above all others?
The dollar is weak (UUP), thanks to endless talk about trade wars.
Anecdotal evidence of inflation is everywhere. By this I mean that the price is rising for everything you have to buy, like your home, health care, college education, and website upgrades, while everything you want to sell, such as your own labor, is seeing the price fall.
We're not in a recession yet. Call this a pre-recession, which is a long-leading indicator of a stock market top. The real thing shouldn't show until late 2019 or 2020.
There was a kerfuffle over the outlook for Apple (AAPL) last week, which temporarily demolished the entire technology sector. iPhone sales estimates have been cut, and the parts pipeline has been drying up.
If you're a short-term trader, you should have sold your position in April 13 when I did. If you are a long-term investor, ignore it. You always get this kind of price action in between product cycles. I still see $200 a share in 2018. This too will pass.
This month, I have been busier than a one-armed paper hanger, sending out Trade Alerts across all asset classes almost every day.
Last week, I bought the Volatility Index (VXX) at the low, took profits in longs in gold (GLD), JP Morgan (JPM), Alphabet (GOOGL), and shorts in the US Treasury bond market (TLT), the S&P 500 (SPY), and the Volatility Index (VXX).
It is amazing how well that "buy low, sell high" thing works when you actually execute it. As a result, profits have been raining on the heads of Mad Hedge Trade Alert followers.
That brings April up to an amazing +12.99% profit, my 2018 year-to-date to +19.75%, my trailing one-year return to +56.09%, and my eight-year performance to a new all-time high of 296.22%. This brings my annualized return up to 35.55% since inception.
The last 14 consecutive Trade Alerts have been profitable. As for next week, I am going in with a net short position, with my stock longs in Alphabet (GOOGL) and Citigroup (C) fully hedged up.
And the best is yet to come!
I couldn't help but laugh when I heard that Republican House Speaker Paul Ryan announced his retirement in order to spend more time with his family. He must have the world's most unusual teenagers.
When I take my own teens out to lunch to visit with their friends, I have to sit on the opposite side of the restaurant, hide behind a newspaper, wear an oversized hat, and pretend I don't know them, even though the bill always mysteriously shows up on my table.
This will be FANG week on the earnings front, the most important of the quarter.
On Monday, April 23, at 10:00 AM, we get March Existing-Home Sales. Expect the Sohn Investment Conference in New York to suck up a lot of airtime. Alphabet (GOOGL) reports.
On Tuesday, April 24, at 8:30 AM EST, we receive the February S&P CoreLogic Case-Shiller Home Price Index, which may see prices accelerate from the last 6.3% annual rate. Caterpillar (CAT) and Coca Cola (KO) report.
On Wednesday, April 25, at 2:00 PM, the weekly EIA Petroleum Statistics are out. Facebook (FB), Advanced Micro Devices (AMD), and Boeing (BA) report.
Thursday, April 26, leads with the Weekly Jobless Claims at 8:30 AM EST, which saw a fall of 9,000 last week. At the same time, we get March Durable Goods Orders. American Airlines (AAL), Raytheon (RTN), and KB Homes (KBH) report.
On Friday, April 27, at 8:30 AM EST, we get an early read on US Q1 GDP.
We get the Baker Hughes Rig Count at 1:00 PM EST. Last week brought an increase of 8. Chevron (CVX) reports.
As for me, I am going to take advantage of good weather in San Francisco and bike my way across the San Francisco-Oakland Bay Bridge to Treasure Island.
Good Luck and Good Trading.
Global Market Comments
April 19, 2018
Fiat Lux
Featured Trade:
(DIVING BACK INTO THE VIX),
(VIX), (VXX), (SPX),
(THE GREAT AMERICAN JOBS MISMATCH)
I think we are only days, at the most weeks, away from the next crisis coming out of Washington. It can come for any of a dozen different reasons.
Wars with Syria, Iran or North Korea. The next escalation of the trade war with China. The failure of the NAFTA renegotiation. Another sex scandal. The latest chapter of the Mueller investigation.
And then there's the totally unexpected, out of the blue black swan.
We are spoiled for choice.
For stock investors, it's like hiking on the top of Mount Whitney during a thunderstorm with a steel ice axe in hand.
So, I am going to buy some fire insurance here while it is on sale to protect my other long positions in technology and financial stocks.
Since April 1, the Volatility Index (VIX) has performed a swan dive from $26 to $15, a decline of 42.30%.
I have always been one to buy umbrellas during parched summers, and sun tan lotion during the frozen depths of winter. This is an opportunity to do exactly that.
Until the next disaster comes, I expect the (VXX) to trade sideways from here, and not plumb new lows. These days, a premium is paid for downside protection.
The year is playing out as I expected in my 2018 Annual Asset Class Review (Click here for the link.). Expect double the volatility with half the returns.
So far, so good.
If you don't do options buy the (VXX) outright for a quick trading pop.
You may know of the Volatility Index from the many clueless talking heads, beginners, and newbies who call (VIX) the "Fear Index."
For those of you who have a PhD in higher mathematics from MIT, the (VIX) is simply a weighted blend of prices for a range of options on the S&P 500 index.
The formula uses a kernel-smoothed estimator that takes as inputs the current market prices for all out-of-the-money calls and puts for the front month and second month expirations.
The (VIX) is the square root of the par variance swap rate for a 30-day term initiated today. To get into the pricing of the individual options, please go look up your handy-dandy and ever-useful Black-Scholes equation.
You will recall that this is the equation that derives from the Brownian motion of heat transference in metals. Got all that?
For the rest of you who do not possess a PhD in higher mathematics from MIT, and maybe scored a 450 on your math SAT test, or who don't know what an SAT test is, this is what you need to know.
When the market goes up, the (VIX) goes down. When the market goes down, the (VIX) goes up. Period.
End of story. Class dismissed.
The (VIX) is expressed in terms of the annualized movement in the S&P 500, which today is at $806.06.
So, for example, a (VIX) of $15.48 means that the market expects the index to move 4.47%, or 121.37 S&P 500 points, over the next 30 days.
You get this by calculating $15.48/3.46 = 4.47%, where the square root of 12 months is 3.46 months.
The volatility index doesn't really care which way the stock index moves. If the S&P 500 moves more than the projected 4.47%, you make a profit on your long (VIX) positions. As we know, the markets these tumultuous days can move 4.47% in a single day.
I am going into this detail because I always get a million questions whenever I raise this subject with volatility-deprived investors.
It gets better. Futures contracts began trading on the (VIX) in 2004, and options on the futures since 2006.
Since then, these instruments have provided a vital means through which hedge funds control risk in their portfolios, thus providing the "hedge" in hedge fund.
If you make money on your (VIX) trade, it will offset losses on other long positions. This is how the big funds most commonly use it.
If you lose money on your long (VIX) position, it is only because all your other long positions went up.
But then no one who buys fire insurance ever complains when their house doesn't burn down.
"Chance Favors the Prepared," said French scientist Louis Pasteur.
Global Market Comments
April 11, 2018
Fiat Lux
Featured Trade:
(TRADING THE NEW VOLATILITY),
(VIX), (VXX),
(THE TWO CENTURY DOLLAR SHORT), (UUP)
I have been trading the Volatility Index (VIX) since it was first created in 1993.
Let me tell you, the Volatility Index we have today is not your father's Volatility Index.
The (VIX) was originally a weighted measure of the implied volatility of just eight S&P 100 at-the-money put and call options.
Ten years later, in 2004, it expanded to use options based on a broader index, the S&P 500, which allows for a more accurate view of investors' expectations on future market volatility. That formula continues until today.
There were two generational lows in the (VIX) that have taken place since inception.
The first was in 1998 during the heyday of the mammoth hedge fund Long-Term Capital Management. The firm sold short volatility down to the $8 level and used the proceeds to buy every bullish instrument in the universe, from Japanese equities to Danish mortgage bonds and Russian government debt.
Then the Russian debt default took place and the (VIX) rocketed to $40. LTCM suffered losses in excess of 125% of its capital, and went under in two weeks. It took two years to unwind all the positions, while the (VIX) remained $40 for a year.
To learn more detail about this unfortunate chapter in history, please read When Genius Failed by Roger Lowenstein. The instigator of this whole strategy, John Meriwether, once tried to hire me and is now safely ensconced in a massive estate at Pebble Beach, CA.
The second low came in January of 2018, when the (VIX) traded down to the $9 handle. This time around, short exposure was industrywide. By the time the (VIX) peaked on the morning of February 6, some $8 billion in capital was wiped out.
So here we are back with a (VIX) of $20.48. But I can tell you that there is no way we have a (VIX) $20.48 market.
This is because (VIX) is calculated based on a daily closing basis. It in no way measures intraday volatility, which lately has become extreme.
During 11 out of the last 12 trading days, the S&P 500 intraday range exceeded 2%. This is unprecedented in stock markets anywhere any time.
It has driven traders to despair, driven them to tear their hair out, and prompted consideration of early retirements. The price movements imply we are REALLY trading at a (VIX) of $50 minimum, and possibly as high as $100.
Of course, everyone blames high frequency traders, which go home flat every night, and algorithms. But there is a lot more to it than that.
Heightened volatility is normal in the ninth year of a bear market. Natural buyers diminish, and volume shrinks.
At this point the only new money coming into equities is through corporate share buybacks. That makes us hostage to a new cycle, that of company earnings reports.
Firms are now allowed to buy their own stock in the run up to quarterly earnings reports to avoid becoming afoul of insider trading laws. So, the buyers evaporate a few weeks before each report until a few weeks after.
So far in 2018 this has created a cycle of stock market corrections that exactly correlate with quiet periods. This is when the Volatility Index spikes.
And because the entire short volatility industry no longer exists, the (VIX) soars higher than it would otherwise because there are suddenly no sellers.
So, what happens next when companies start reporting Q1, 2018 earnings? They announce large increases in share buybacks, thanks to last year's tax bill. And a few weeks later stocks take off like a scalded chimp, and the (VIX) collapses once again.
That's why the Mad Hedge Fund Trader Alert Service is short the (VIX) through the IPath S&P 500 VIX Short Term Futures ETN (VXX) April, 2018 $60-$65 in-the-money vertical bear put spread.
Just thought you'd like to know.
After ignoring the constant chaos in Washington for 17 months, it finally mattered to the stock market.
Guess what was at the top of the list of retaliatory Chinese import duties announced last week?
California wine!
The great irony here is that half of the Napa Valley wineries are now owned by Chinese investors looking for a bolt-hole from their own government. Billionaires in China have been known to disappear into thin air.
And after years of trying, we were just getting Chinese consumers interested in tasting our fine chardonnays, merlots, and cabernet sauvignons.
It will be a slap in the face for our impoverished farmworkers who actually pick the grapes, who have just been getting back on their feet after last fall's hellacious fires.
Do you suppose they will call the homeless housing camps "Trumpvilles?"
California is on the front line of the new trade war with China.
Not only is the Middle Kingdom the largest foreign buyer of the Golden State's grapes, almonds, raisins, and nuts, it also is the biggest foreign investor, plowing some $16 billion in investments back here in 2016.
Down 1,700 Dow points on the week and a breathtaking 1,400 points in two days. It was the worst week for the markets in two years. And the technology and financial stocks suffered the worst spanking - the two market leaders. The most widely owned stocks are seeing the worst declines.
We certainly are paying the piper for our easy money made last year. The Dow Average is now a loser in 2018, off 4.1% and back to November levels.
The Dow 600 point "flash crash" we saw in the final two hours of trading on Friday was almost an exact repeat of the February 9 swoon that took us to the exact same levels.
There was no institutional selling. It was simply a matter of algorithms gone wild. The news flow that day was actually quite good.
Our favorite stock, Micron Technology (MU) announced blockbuster earnings and high target (for more depth, please read the Mad Hedge Technology Letter).
Dropbox (DBX) went public, and immediately saw its shares soar by 50% in the aftermarket. The president signed an emergency funding bill to keep the government open, despite repeated threats not to do so.
Which means the market fell not because of a fundamental change in the US economy. It is a market event, pure and simple.
I therefore expect a similar outcome. Only this time, we don't have an $8 billion unwind of the short volatility trade ($VIX) to deal with, as we did in February. That's why I thought markets would bottom at higher levels this time around.
There is only one problem with this theory.
The chaos, turmoil, and uncertainty in Washington is finally starting to exact a steep price on shareholders. Uncertain markets commend lower price earnings multiples than safer ones.
As a result, multiples are now 15% lower than the January high at 19.5X, and much more for individual stocks. And multiples have been falling even though earnings have been rising, quite substantially so. Such is the price of chaos.
Will markets bottom out here on a valuation basis as they did last time? Or will the continued destruction of our democracy command a higher price? We will find out soon.
Clearly the S&P 500 200-day moving average at $255.95 is crying out for a revisit, which we probably will see first thing Monday morning. Allow more shorts to get sucked in, and then you probably have a decent entry point to buy stocks for the rest of 2018.
Indeed, it was a week when the black swans alighted every day. First, the twin hits from Facebook (FB), followed by the worst trade war in eight decades. Then came the Chinese retaliation.
While the damage suffered so far has been limited, investors are worried about what is coming next.
One of the last supervising adults left the White House, my friend and comrade in arms, National Security Advisor H.R. McMaster. His replacement is Fox News talk show host John Bolton, who is openly advocating that the US launch a pre-emptive nuclear strike against North Korea.
Bolton has quite a track record. He is the guy who talked President Bush into invading Iraq. Now, that would trigger a new bear market in the extreme!
As I did not predict five black swans in five days, the Mad Hedge Trade Alert Service took a hit this week, backing off of fresh all-time highs.
The trailing 12-month return fell to 46.49%, the 8-year return to 284.01%, bringing the annualized average return down to only 34.08%.
Given all of the above, economic data points for the coming holiday shorted trading week seem almost quaintly irrelevant. But I'll give them to you anyway.
On Monday, March 26, at 10:30 AM, we get the February Dallas Fed Manufacturing Survey.
On Tuesday, March 27, at 9:00 AM, we receive an update on the all-important CoreLogic Case-Shiller National Home Price NSA Index for January. A 3-month lagging housing indicator.
On Wednesday, March 28, at 8:30 AM EST, the second read of Q1 GDP comes out.
Thursday, March 29, leads with the Weekly Jobless Claims at 8:30 AM EST, which hit a new 49-year low last week at an amazing 210,000. At 9:45 AM, we get the February Chicago Purchasing Managers Index. At 1:00 PM, we receive the Baker-Hughes Rig Count, which saw a small rise of three last week.
On Friday, March 30, the markets are closed for Good Friday.
As for me, I'll be doing my Christmas shopping early this year before the new Chinese import tariffs jack up the price for everything by 15% to 25%.
I'll be doing all of this courtesy of Amazon (AMZN), of course. Since I arrived here at Lake Tahoe, it has snowed 6 feet in two days in a storm of truly biblical proportions. We got a total of 18 feet of snow in March. By the time I dig out, it will be time to go home.
Good luck and good trading.
John Thomas
I am one of those cheapskates who buys Christmas ornaments by the bucket load from Costco in January for ten cents on the dollar because my eleven month return on capital comes close to 1,000%.
I also like buying flood insurance in the middle of the summer when the forecast here in California is for endless days of sunshine.
That is what we are facing now with the volatility index (VIX) where premiums have been hugging the 12%-14%% range recently. Get this one right, and the profits you can realize are spectacular.
The CBOE Volatility Index (VIX) is a measure of the implied volatility of the S&P 500 stock index, which has been melting since the ?RISK OFF? died a horrible death.
You may know of this from the talking heads, beginners, and newbies who call this the ?Fear Index?. Long-term followers of my Trade Alert Service profited handsomely after I urged them to sell short this index at the heady altitude of 47.
For those of you who have a PhD in higher mathematics from MIT, the (VIX) is simply a weighted blend of prices for a range of options on the S&P 500 index. The formula uses a kernel-smoothed estimator that takes as inputs the current market prices for all out-of-the-money calls and puts for the front month and second month expirations.
The (VIX) is the square root of the par variance swap rate for a 30 day term initiated today. To get into the pricing of the individual options, please go look up your handy dandy and ever useful Black-Scholes equation. You will recall that this is the equation that derives from the Brownian motion of heat transference in metals. Got all that?
For the rest of you who do not possess a PhD in higher mathematics from MIT, and maybe scored a 450 on your math SAT test, or who don?t know what an SAT test is, this is what you need to know. When the market goes up, the (VIX) goes down. When the market goes down, the (VIX) goes up. End of story. Class dismissed.
The (VIX) is expressed in terms of the annualized movement in the S&P 500, which today is at 1,800. So a (VIX) of $14 means that the market expects the index to move 4.0%, or 72 S&P 500 points, over the next 30 days. You get this by calculating $14/3.46 = 4.0%, where the square root of 12 months is 3.46.
The volatility index doesn?t really care which way the stock index moves. If the S&P 500 moves more than the projected 4.0%, you make a profit on your long (VIX) positions.
Probability statistics suggest that there is a 68% chance (one standard deviation) that the next monthly market move will stay within the 4.0% range. I am going into this detail because I always get a million questions whenever I raise this subject with volatility-deprived investors.
It gets better. Futures contracts began trading on the (VIX) in 2004, and options on the futures since 2006. Since then, these instruments have provided a vital means through which hedge funds control risk in their portfolios, thus providing the ?hedge? in hedge fund.
But wait, there?s more. Now, erase the blackboard and start all over. Why should you care? If you buy the (VIX) here at $14, you are picking up a derivative at a nice oversold level. Only prolonged, ?buy and hold? bull markets see volatility stay under $14 for any appreciable amount of time.
If you are a trader you can buy the (VIX) somewhere under $14 and expect an easy double sometime in the coming months. If we get another 10% correction somewhere along that way, that would do it.
If you are a long-term investor, pick up some (VIX) for downside protection of your long-term core holdings. A bet that euphoria doesn?t go on forever and that someday something bad will happen somewhere in the world seems like a good idea here.
If you don?t want to buy the (VIX) futures or options outright, then you can always buy the iPath S&P 500 VIX Short Term Futures ETN (VXX). Easier still is the (UVXY), which is particularly useful for trading narrow ranges like the one we have had.
If you lose money on this trade, it will only be because you have made a fortune on everything else you made. No one who buys fire insurance ever complains when their house doesn?t burn down.
Followers of my Trade Alert service have noticed some unusual activity during the last two days. Instead of recommending put spreads, I have started advising the purchase of outright puts.
Coming on top of big declines in the S&P 500 (SPY), you may have thought that I have lost my mind, if I hadn?t already done so a long time ago.
My kids would agree with you.
However, there is a method to my madness.
The truly brilliant aspect to the option spread strategy that I have been using for the past four years was that the positions had an embedded short volatility aspect to them.
While you were long volatility with your long leg, this was offset by the short volatility in your short leg.
This gave you a net volatility exposure of close to zero, a great thing to have during a time of secular declining volatility, as we have seen since 2012. Think of the first eight months of 2015, when index prices barely budged.
It also meant that you could achieve your maximum profit when the underlying stock remained unchanged, or moved only a few percent against you.
The nice thing about this low volatility was that it gave time to followers to get in and out of positions before large price changes occurred. Moves of only a few cents before you received trade alerts were common.
By focusing on front month options I also took maximum advantage of accelerated time decay going into each expiration. It was like having a rich uncle write you a check every day.
The low volatility delivered only small changes in the value of your portfolio from the day-to-day movements in the market, tiny enough for the novice investor to live with.
This is what enabled me to produce huge, outsized double digit returns while most other managers were sucking wind.
Since August 24, we have been in a completely different world. The long-term trend in volatility isn?t falling anymore. It has been rising.
What this brought to my trading book was a series of stop outs on options spread positions, whether they were call spreads or put spreads, and painful losses.
This is why I lost money in two out of three months in the recent quarter, a rare event. Having an embedded short volatility position was alas costing me money.
So it is time to adjust our strategy to reflect this brave new, and more volatile world.
So instead of running positions into expiration, I am going to start hedging them with options when a breakdown in the market appears imminent.
This is why I picked up the February $190 puts on Friday to hedge my January $185-$190 calls spread. It is also why I bought the February $187 puts to hedge my January $182-$187 call spread.
Why the mismatch in expirations? It ducks the problem of final week super accelerated time decay with my long puts. It also means I can continue with the short positions after the Friday January expiration, if I choose to do so.
There is one complication with this approach. Individual options are vastly more volatility than option spreads. So it won?t be unusual for an option to move 5%-10% by the time you receive the Trade Alerts. To be forewarned is to be forearmed.
Let?s look at out current positions as examples. For further analysis you have to be familiar with the concept of on option delta. Delta is a letter of the Greek alphabet used by traders to refer to the movement of an option relative to its underlying security.
A delta of 10% means that a $1 move in the underlying produces a 10-cent move in the option, which you see in deep out-of-the-money options. A delta of 90% means that a $1 move in the underlying produces a 90-cent move in the option, which is found with deep-in-the-money options.
The January $185-$190 vertical call debit spread had two legs, and the delta can be calculated as following:
A long January 185 call with a delta of +19%
A short January 190 call with a delta of -39% (negative since you are short)
This gives you a net delta of (39% - 19%) = -20%.
In other words, a $1 move down in the underlying (SPY) index only moves the $185-$190 call spread south by -20 cents.
In the case of the $182-$187 call spread, the net delta is only 14%, giving you a move in the spread of only 14 cents for the $1 (SPY) move.
Let?s say that the market looks like it is going to pieces and I want to hedge my downside exposure. That means I need to buy puts against my long call spread.
Since my net delta is only -20% on the January $185-$190 vertical call debit spread, I only need to buy 20% as many puts to neutralize the position, or 0.2 X 22 = 4.4 options.
To be more aggressive on the downside I increased my put purchase to 13 contracts to also provide extra downside protection of my short volatility (XIV) position. I then repeated this exercise on Monday for the $182-$187 vertical call debit spread.
What we end up with is a portfolio that is profitable at all points with a Friday January 15 (SPY) options expiration between $187-$194. Now you don?t have to touch the position, unless we break out of that range.
This prevents you from attempting to trade every triple digit ratchet in the market between now and then. This is a hopeless exercise. I know because I have tried it many times, to no avail.
Yes, I know this all sounds complicated. But this is how the pros do it. This is how they make money. It?s all about preserving your capital and making incremental profits on top of it. Watch, and learn.
Learn from my errors and prosper.
You Get Used to Them After a While
It is often said that the stock market has discounted 12 out of the last four recessions.
While the market is discounting another recession now, I believe it is one of the many previously forecast that will never happen, a lot like to 18% swoon in the futures markets we saw last summer.
If anything, the reported hard data are showing that the economy is strengthening now, not weakening. The December nonfarm payroll hit a one-year high at 292,000. Christmas sales were off the charts for online merchants.
Auto production topped an 18 million rate. And this is an industry that was bankrupt only seven years ago.
But what else would you expect from a global economy that just has a $2 trillion annual tax cut dumped in its lap, thanks to lower energy prices.
I therefore think we are within days of the final capitulation of this move. That means the Volatility Index (VIX) will peak as well, probably around $30, the top that defined the top of every spike for all of 2015, except for the August 24 flash crash day. That apex is probably only days away.
I am one of those cheapskates who buys Christmas ornaments by the bucket load from Costco in January for ten cents on the dollar, because my eleven month theoretical return on capital comes close to 1,000%.
I also like buying flood insurance in the middle of the summer when the forecast here in California is for endless days of sunshine.
That is what we are facing now with the volatility index (VIX) where premiums have just doubled, from $15 to near $30. Get this one right, and the profits you can realize are spectacular.
Watch carefully for other confirming trends to affirm this trade is unfolding. Those would include a strong dollar, collapsing stocks, and oil in free fall, and a weak Japanese yen, Euro.
I don?t know about you, but I am seeing seven out of seven cross asset confirming price action.
The CBOE Volatility Index (VIX) is a measure of the implied volatility of the S&P 500 stock index, which has been rallying hard since oil began its precipitous slide three weeks ago.
You may know of this from the many clueless talking heads, beginners, and newbies who call this the ?Fear Index?. Long-term followers of my Trade Alert Service profited handsomely after I urged them to sell short this index three years ago with the heady altitude of 47%.
For those of you who have a PhD in higher mathematics from MIT, the (VIX) is simply a weighted blend of prices for a range of options on the S&P 500 index. The formula uses a kernel-smoothed estimator that takes as inputs the current market prices for all out-of-the-money calls and puts for the front month and second month expiration's.
The (VIX) is the square root of the par variance swap rate for a 30 day term initiated today. To get into the pricing of the individual options, please go look up your handy dandy and ever useful Black-Scholes equation. You will recall that this is the equation that derives from the Brownian motion of heat transference in metals. Got all that?
For the rest of you who do not possess a PhD in higher mathematics from MIT, and maybe scored a 450 on your math SAT test, or who don?t know what an SAT test is, this is what you need to know. When the market goes up, the (VIX) goes down. When the market goes down, the (VIX) goes up. End of story. Class dismissed.
The (VIX) is expressed in terms of the annualized movement in the S&P 500, which today is at 1,800. So a (VIX) of $14 means that the market expects the index to move 4.0%, or 72 S&P 500 points, over the next 30 days.
You get this by calculating $14/3.46 = 4.0%, where the square root of 12 months is 3.46. The volatility index doesn?t really care which way the stock index moves. If the S&P 500 moves more than the projected 4.0%, you make a profit on your long (VIX) positions.
Probability statistics suggest that there is a 68% chance (one standard deviation) that the next monthly market move will stay within the 4.0% range. I am going into this detail because I always get a million questions whenever I raise this subject with volatility-deprived investors.
It gets better. Futures contracts began trading on the (VIX) in 2004, and options on the futures since 2006. Since then, these instruments have provided a vital means through which hedge funds control risk in their portfolios, thus providing the ?hedge? in hedge fund.
But wait, there?s more. Now, erase the blackboard and start all over. Why should you care? If you sell short the (VIX) here at $24, you are picking up a derivative at a nice overbought level. Only prolonged, ?buy and hold? bull markets see volatility stay under $14 for any appreciable amount of time. That?s probably what we have now.
If you are a trader you can sell short the (VIX) futures somewhere over $20 and expect an easy profit sometime in the coming weeks. If we get another 5% rally somewhere along that way, that would do it.
If you don?t want to sell the (VIX) futures or options outright, then you can always sell short the iPath S&P 500 VIX Short Term Futures ETN (VXX). Better yet, you can buy a short (VIX) ETN outright, the Velocity Shares Daily Inverse VIX Short Term ETN (XIV).
If you make money on this trade, it will offset losses on other long positions.
No one who buys fire insurance ever complains when their house doesn?t burn down.
Volatility Can Be Your Friend