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

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

Long-term, stock prices as a group tend to rise at 9 – 10% a year. The industry likes to reinforce that idea by keeping the public’s attention on market indexes of many stocks – at least 30 in the Dow Jones Industrials, 100 in the Nasdaq, and 500 in the S&P500.

By combining the diverse price actions of many stocks in these indexes and reporting on their small combined price moves day by day, it appears that only modest changes may be going on. Maybe it’s just another year when market prices rise their usual +9%, or maybe a bad year when they decline -5%.

But let’s look at what is happening to specific stocks’ prices. After all, they are what you may be investing in and risking your capital through.

I systematically follow about 2,500 stocks, ETFs, ADRs, and indexes on a daily basis. In 2007, there were only 74 that had price ranges during the year, low to high, of less than 20%. There were also 221 that had price ranges of 100% or more.

These are all stocks the academics and economists tell you that go up some 9-10% a year on average. You’re aware, of course, of the statistician that drowned while wading across a pond that was only 2 feet deep, on average?

That 9-10% is what physicists call signal. The 100%+ is what they call noise.

Both offer opportunity. But where is the greatest, most frequent opportunity?

The average price swing during the year was about 68%, several times that 9-10% trend. And 2007 was not an unusual year in the market. Not like 2008.

As important, how long did it take a typical stock to make its traverse? About 7 months. So the value of perfect information (i.e. hindsight) was an annual rate of change equal to 222%. That’s the gain you might have had with a perfectly timed buy and perfectly timed sell, on stocks representative of the average, that could employ your capital fully over the year.

Not likely, so what are the odds that good timing could do better than the 9-10% trend? We can get a sense of the answer by finding out how many stocks out of the total produce a price upswing gain greater than that. The answer, in 2007, was 65% of them – even when we recognize that many of the stocks’ price swings were downward.

Big potentials exist in the noise. And they are magnified by the time component. More about that another time. Till then, make some money for yourself in the market.

Peter Way, CFA

Our Approach ETF Investing, peter way, stock market theory, trading strategy