($VIX) Archives

Volatility Melt Down Continues

The market was buzzing today about the continued collapse of volatility and the significance thereof today. Today the chief whipping boy was the double leveraged Velocity Shares 2X Vix ETF (TVIX), which cratered 33% on the day, and down 90% from its October high.

This was on a day when the ETF should have gone through the roof, with the Dow down 100 points and a rapidly deteriorating Chinese Purchasing Managers Index threatening of worse to come. Even the (VIX) and the (VXX) only brought in modest gains at best. Against this backdrop they should have been up much more.

Conspiracy theories abounded. Some speculated about margin calls on a major hedge fund triggering a forced liquidation. Other?s thought that complacency was peaking, creating spike bottoms in volatility products that could signify a final move. Certainly a buying opportunity is setting up here, but how do you determine where when the ETF is doing the exact opposite of what it is supposed to do.

Whatever the reason, investors? trust in these instrument has been permanently dented. A 33% one day drop certainly was not in the prospectus.

What?s Going on With the VXX?

Newsletter

Much of Wall Street was scratching their heads yesterday as the iPath S&P 500 Vix Short Term Futures ETN (VXX) plunged to new lifetime lows despite a 69 point decline in the Dow index. It wasn?t supposed to work that way. Falling markets should send investors scrambling to buy downside protection in the form of put options which would automatically send the volatility index skyward. Except when they don?t.

I spoke to over 30 market participants yesterday attempting to root out the cause of this seeming anomaly. All I got was shrugs or idle speculation. A (VXX) at this level assumes that the complacency now endemic in the market will continue for several more months. It is betting that the S&P 500 will continue moving sideways or up with no pull backs greater that 2%. Oh, really?

It is also discounting a rise in the (SPX) to 1,500, based on a multiple expansion from 14 to 15, while corporate earnings are falling. This will see confirmation when Q1, 2012 earnings start to hit in April. Oh, really again? It will do this in the face of economies that are dramatically slowing in both Europe and china while oil prices are spiking. Oh, really, a third time?

I finally got through to some friends in the Chicago pits who explained what was going on. A sizeable portion of the trading community believes that we will see a rise in volatility someday, but not in the near future. So they have been buying June and September call option in the volatility index (VIX). To pay for these they have been selling short calls in the front month April and May calls.

Since the (VXX) focuses on only the front two months of the options calendar, it has taken an inordinate brunt of the selling. This is why the (VXX) has continued a rapid decent even on days when the (VIX) was stable and the Dow was down. The first hint we got of this was on Monday, March 12 when traders started to roll in earnest from the March to the April (VIX) contract.

When they started executing this trade in December, both the short term and long term volatility were trading around 28. Holding a June or September call while selling calls for each expiring month against it has kept long dated volatility high at 28, but driven short term volatility down to an eye popping 14. Needless to say, it has been a huge money maker for the early participants.

How does this end? At some point we do get a serious sell off in the stock market, and the (VIX) rockets back up to 28 or higher. That means that anyone who initiates this position now will get slaughtered. But the long term players will simply write those losses off against the substantial short dated premium they have taken in in the meantime.

As long as this dynamic is in place, there really is no limit to how far the (VXX) can fall. As traders roll from one expiring month to the next, they will continue to hammer volatility. So when the (VXX) hit my stop loss at $20, the previous lifetime low for this contract, I let it stand and followed up with a trade alert reminder investors to bail.

Any loss that you don?t learn from is a wasted lesson that is bound to be repeated. The key in this situation is to make sure the hits don?t become life threatening by limiting them to small single digits. The combined loss of my two errant (VXX) trades came to -3.46% for my notional $100,000 portfolio. That is not the end of the world. It simply cancels out the profits I made earlier on my short positions in the Japanese yen and natural gas, as well as my long call spreads in Apple and Microsoft. Coming out here also lets me shrink and neutralize my book, a good think in these uncertain times.

I?m sure we?ll see the (VXX) above $30 sometime this year. I just don?t want to bleed to death before it happens.

Markets Can Remain Irrational Longer Than you Can Remain Solvent

Buy Flood Insurance With the VIX

Newsletter

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 just broken under 20%, a six month low. 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? trade peaked in early October. 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 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 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. So today?s (VIX) of $19 means that the market expects the index to move 5.5%, or 72 S&P 500 points, over the next 30 days. You get this by calculating $19/3.46 = 5.5%, 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 5.5%, 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 5.5% 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 $19, you are picking up a derivative at a nice oversold level. Only prolonged, ?buy and hold? bull markets see volatility stay under $20 for any appreciable amount of time.

If you are a trader you can buy the (VIX) somewhere under $20 and expect an easy double sometime this year. 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.

Cross Market Correlations Are Breaking Down

Diary

Today was a real head scratcher for long time market observers, including myself. Cross market correlations that have served me so well this year are breaking down, and their predictive power has suddenly gone blind. I blame this on the liquidity drought that has plagued the market since the beginning of the month that has confined markets to frustratingly narrow ranges.

There are many reasons for the sudden opacity. The usual seasonal flight to the sidelines seems more pronounced than in years past, as many managers attempt to put a dreadful year behind them. There is still $500 million in trading capital missing from traders who used MF Global as a prime broker. This is especially felt in the energy and metals markets where MF had such a large presence.

High frequency traders have also decamped for more fertile climes in the oil and foreign exchange markets. And we all know that the big hedge funds are getting redemptions, cutting them off at the knees until January.

I?ll give you a few examples. Falling stock markets almost always produce a rising volatility index. But today it fell as low as 23%, a five month low, and closed at only 25.4% even with the Dow off 66 points. The correlation between stocks and gold has been almost perfect since the summer. But the barbarous relic has been in free fall since yesterday with the S&P 500 essentially unchanged. Ditto with the Euro, which managed a two cent plunge today.

The larger question for traders is whether this is a onetime only breakdown in cross market linkages that will end in January, or is it the beginning of a more permanent continental drift. We will find out next month when the ?A? Team managers return to the market and volume recovers.

Let me toss an alternative theory out there. It appears that the year to date returns for all asset classes are rapidly converging on zero. That?s why assets like gold and silver with the great 12 month returns are having the biggest falls this week. The S&P 500 is now down 2.2% on the year, and the Euro is up a miniscule 1.1%. Gold is still hanging on to a 17% gain, while silver is up only 12%, both rapidly headed towards single digits

Is this the inevitable result of a ?no return? world? Sounds like I better stay out of the market in this performance sapping environment, lest my own profits go up in a puff of smoke.

The ?A? Team Traders Are Gone Until January

Watch Out for the Bear Trap

Diary

The volatility index (VIX) is just not buying this sell off. Even with the Dow down over 300 today, the (VIX) has only managed a meager 3% gain on the day. With a move in equities of this magnitude, you would expect volatility to rise by 15% or more. If traders and investors really believed that the risk markets were really going to crash to new lows, they would be paying through the nose to buy downside protection, which would be clearly visible in a (VIX) spike. These figures prove they aren?t.

Let?s do a quickie cross asset class review here and look at what else on the table. The S&P 500 is precisely at the 50% retracement of the entire 200 point move up from October 4. It could hold this level and keep the bull move intact. While junk bonds (HYG) are down, they are nowhere near the levels suggesting that a financial collapse is imminent. Advance decline ratios are at all-time highs, not exactly an argument for a new bear market. Nor are Treasury bonds drinking the Kool-Aide. Sure they are up today, but not as much as they should be.

It all has the makings of an asymmetric trade for me. That means that the next piece of good news will deliver a larger move up than the next piece of bad news will bring a down one. So a tactical long here will bring an outsized returns. It could well be that the failure of the Super committee is fully in the price, and the mere passage of the deadline might bring a big rally. There are certainly a lot of hedge funds looking to chase yearend performance and value players happy to bottom fish to pull this off.

The bulls also have the calendar strongly in their favor. Not only is the November-December period the second strongest bimonthly period of the year, investors are massively underweight equities. As I never tire in explaining to my permabear friends, most investors can?t sell stock they don?t own. That?s why the Armageddon scenario never kicked in during September. That leaves hedge funds and high frequency trading alone to break the downside supports, something they have so far been unable to do alone.

Which girls will get invited to the next dance? The same ones taken to the last one: commodities, energy, rail, coal, and technology stocks, especially Apple, which is sitting bang on its 200 day moving average today.

Of course I could be wrong about all of this. Conditions in the markets are so uncertain here that there are no real high quality trades to be found. Almost everyone is posting negative returns this year, including some of the smartest people I know. That?s why I have pared back my own trading in order to preserve my own 42% year to date gain. But then, I am 75% in cash, so I can afford to take a relaxed view of things.

Only trade here if your wife is pestering you for a larger Christmas shopping budget. Don?t even think about opening up a new short here, because you have already missed the big, easy move. Then again, you could consider getting a new wife. It might be cheaper.

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