Play the Players

The VIX index, a measure of anticipated market VOLATILITY or UNCERTAINTY, gets labeled the “fear index” and appears to jump around almost erratically.

Unless you are skilled in options trading, the VIX may only be a curiosity.

Now there are both VIX futures (CBOE/FCE) and a VIX-related ETN (VXX) available to play with. Don Fishback has just written a very good Graham&Dodd analysis of the VXX at Seeking Alpha that should discourage anyone from exploring that ETN with real money.

Especially those who learned that, no matter how smart you think you are, investing in things you don’t really understand can be detrimental to everyone’s economy, including yours.

What is not often recognized by casual observers is that the VIX itself has options that can be traded. Skilled options traders usually employ them to get big leverage advantages when they are convinced a directional play in the market is at hand.

The VIX tends to be a contra indicator, being low when markets have built up strong advances and everything looks too good to go wrong … go wrong … go wrong, and then jumps up high when it does and no one seems to know where the bottom will be.

For a long time the VIX seemed to range over a span of 10 at the low end to 40 at its tops, with 20 or so sort of a central tendency. But then came last year’s September Crisis and the VIX rocketed to 80.

As things struggled to get back to normal the VIX hovered between 40 and 60 until the notion became accepted that perhaps a bottom had been reached in March. Since then the VIX has gradually been working its way down to between 20 and 40.

But as that has been going on, and particularly of late, the market has been undergoing short spasms of decline and recovery. One currently is in progress. The last 4 days has seen the VIX jump from 20 to 28, a 40% advance. Some VIX options are up +100% or more. The S&P500, or SPX, has declined by -4 1/2%.

Wouldn’t it be great to know when to get aboard that kind of a ride?

This is speculation, not investing. But because there seems always to be an appetite for such gambles, I’ll let you in on what we find in looking at how the options pro traders are behaving.

The analysis is the same as what we use to identify the expectations of the big volume market makers in stocks. Here the players are a different bunch, with very different tempraments and behavior limits. But they are driven to operate from the same set of logical rules while seeking low-risk, high-probability profits.

The accompanying chart shows what the options pros must believe could (not will) happen to the VIX’s price in the near future — two weeks to two months. The green days are where the expectations range is virtually all higher than the heavy dots that mark the end-of-day values for the VIX.

On a short-term basis the VIX typically moves contrary to the SPX. Under the right extreme circumstances expectations for changes in the VIX can point to changes in the S&P500. Here is a picture of how nearby SPX moves relate to where VIX expectations are in terms of its present price. (The VIX metric is like a stochastic, but uses our derived forecasts rather than backward-looking price history.)

Draw your own conclusions.

Recent News Market Forecasts, trading strategy

We say yes, and here’s why.

We derive forecasts from the hedging actions of the block trading community on over 2,000 widely-held and actively-traded stocks, ADRs, and ETFs. The common denominators of upside and downside price move potentials are present in all of the forecasts. The uncertainty involved in each is indicated by combining the up and down.

Those common denominators let us aggregate expectation descriptors for the equity market as a whole, or for any subset of interest. To put the overall market in a picture many stock investors can relate to, we took the recent price history of the S&P500 index, and expanded it to embrace the daily average upside and downside expectations of our entire population.

What appears immediately is the way fears and hopes expand the range of expectations when the market is rapidly and substantially declining. Less obvious, but also present is the “What, me worry?” attitude of investors in rising markets. Then the range of uncertainty shrinks.

These effects are more apparent in the following picture:

In the 2008 May-July market decline downside concerns widened only a bit, while upside hopes stayed high. Those hopes were modestly rewarded by a market rally into September. But as declines began again the downside apprehensions expanded and then mushroomed into a panic, along with plunging prices.

The convictions of optimists are hard to kill off, fortunately, so upside potentials widened appropriately for many stocks, expanding that dimension’s average.

While the market stabilized as year-end approached, the downside fears subsided back to earlier levels. But more bad news lay ahead, and further market declines into early March of this year repeated prior investor responses. Still, they were not as extreme as before.

Nor were they in early July as a month’s worth of declining market index numbers tested investors’ convictions. Then downside expectations did not expand much, and the market rejoined the recovery path.

Now the question turns to can it continue? Is it “what, me worry?” time?

That attitude may have started to appear in early September when downside concerns greatly diminished. They were accompanied by reduced upside convictions, and the level of blue-line uncertainty dropped to a level not seen in over a year.

The following couple of weeks’ pullback shook off the complacency, and once more the raised levels of concern were less severe on the downside than previously. But so were the enthusiasms of the upside. Yet uncertainty remains in a healthy range.

Looking back at the first chart, the S&P500 index price continues to be accompanied by upward trending lows and solid to up-trending highs. Behavior of the lows is most encouraging. Our conclusion is that the overall recovery continues, showing no signs that investors are likely to precipitate a serious downturn, absent the introduction of some new momentous disruptive event.

That appears to be a direct parallel as block traders are hedging their at-risk positions when filling trades in SPY, the S&P 500 SPDR. Their current forecasts are for a range of $104 to $118, +8 ½% on the upside, and – 4 ½% on the downside.

Over the past five years 129 forecasts with similar upside to downside proportions, or better, have seen higher SPY prices in 2/3rds of the days of the following 3 months, averaging +16%, and lower prices in the other 1/3^rd, averaging -14%. Buy and 3-month hold gains outweighed losses 1.9 to 1. SPY now ranks better on a reward-to-risk scale than 74% of the 2,000+ issues we follow.

Peter Way Associates has no present investments in SPY.

Recent News Market Forecasts

Poor Goldman Sachs, they had two trading days last calendar quarter when they LOST money!

When you learn that in 46 of the other 63 days they made over $100 million each day, it is clear that they aren’t taking unnecessary risks. In fact, very few risks at all.

The art form is called hedging, or arbitrage. During the quarter 78% of their profits came from the proprietary trading desk, where it is actively practiced.

These days hedging is made easier by the availability of highly liquid, easily tradable Exchange Traded Funds (ETFs). On Friday over 1.8 billion shares of them were traded, out of a total of 3.5 billion shares between the NYSE and NASDAQ.

That’s right, over half of the trading volume was in ETFs. I wonder who’s doing it. I didn’t trade any 18 million shares (just 1%) on Friday. Did you?

That ETF volume was at an average of $40 a share, worth $73 billion. And this is in the heart of the summer vacation season, when activity is pretty quiet.

Now, if Goldman Sachs made another $100 million on Friday, their vig on just the trading value in ETFs was only 14 basis points, 1/7^th of one percent. Pretty small.

But they don’t do all the trading in ETFs, they have the company of Morgan Stanley, Mother Merrill, Citi, and others.

Hedging these days is made much easier for us common folk by the availability of ETFs that are engineered so that long positions are the same as being short an index, or whatever the ETF is tracking. No margin account is needed, nor any pledge of capital or impairment of borrowing capacity. Just an ordinary cash account at the broker.

Further, many of the short, or inverse ETFs also have a built-in leverage that magnifies the price moves by either two or three. Again, they’re available without any of the usual broker or bank borrowing encumbrances.

These are popular vehicles for risk management. ProShares, the largest provider of leveraged and inverse ETFs, saw $9 billion of trading in their products, just on Friday. With all that activity, perhaps something can be learned by checking out whether there is more enthusiasm for leveraged short ETFs or for leveraged longs.

Here are the upside and downside forecasts of the prop desks and block desks for both sets of ETFs. Any items above the diagonal dotted line have larger downside prospects than upside.

Uncategorized ETF Investing, Market Forecasts, trading strategy