Finance – Page 79

Watch, but not trade volatility

I have discussed this before, but it bears watching. Volatility is at a relative low point in relation to the past thee years:

The events in late 2008 strictly related to the financial crisis (the downfall of Bear Stearns, Lehman), and volatility remained relatively high through the first half of 2009 before calming down.

The markets reached some sort of complacency in the first quarter of this year, before volatility rose again with the advent of the European (Greek) sovereign debt crisis. This resolved, and volatility is dipping again.

It may lower even further, but traditionally volatility is anti-correlated to index performance – the higher volatility goes, the lower the underlying index. Some people have the misconception that the VIX is predictive; it is not, but it can be used as a barometer of market’s future expectations of volatility.

One might be lead into believing that buying and selling volatility itself, compared to the underlying index, may be the financially wise way of playing this. Unfortunately, it is not so easy – the above chart is equivalent to a “spot rate” on volatility – mainly the volatility over the next 30-day period. There are products that are designed to trade volatility directly (VIX futures), but in order to sustain a position, you must take rollover risk.

For example, if you think volatility is going to rise in December, you can buy the December future. But if the volatility does nothing between now and the December expiry (third Friday in December), you must sell your December position (or settle it with cash) and then purchase the January future, which may have a significantly different price than December.

There is an exchange-traded fund, (NYSE: VXX) which performs the same function (for a 0.85% management expense ratio):

As you can compare with the first chart in this post, there is correlation, but during “dull” moments, the ETF is absolutely destroyed by the rollover process. This is similar to most natural resource ETFs (e.g. UNG) which are also destroyed by traders picking away at the automatic rollover.

Rollover risk is somewhat mitigated by the (NYSE: VXZ) ETF, which uses futures that are dated roughly 6 months in advance, but this has tracking error with existing volatility – current volatility may spike, but the future 6 months out might not track the current action.

There is clearly no free lunch in trading volatility – it is not as easy as looking at the VIX chart and thinking you can “buy” it, thinking you are buying low and preparing to sell high. Almost like options, not only must you get the direction correct, but you must get the timing correct, which is not easy.

Traders might be allured by past price action (e.g. this year, doubling your money buying in April, and selling in May), but your timing must be absolutely sharp. There is no way to determine that buying at 75 and selling at 150 was the proper decision except purely in hindsight.

You can even buy options on VXX, but note that the traditional implied volatility calculation (based on the Black-Scholes model) has little to do with properly valuing options on volatility futures – more so with this option than traditional equity options!

Watching carefully

I wish I had something more substantive to write other than to say that I am observing the marketplace, but that is all I have been doing. There are hints of another upcoming economic storm, but it is difficult to say – the messages that my tea leaves give me are very scatter-brained at present. One of the advantages of having a relatively large cash position (the largest I have ever been since 2008) is that you can take advantage of panic, but I do not see panic yet – thus, no point in diving in. I do see a reversal in the markets, but I am not confident in my conviction.

A common question is – if I am convinced we are headed down, why not just sell everything and be in a perfect position to buy cheaply?

The answer is simple – I might be wrong. It could be the case that this selloff in long-term fixed income products is primarily profit taking, or a transient blip in what has been a profitable uptrend. Also, I do not know when the time to “buy cheaply” is. I might miss the opportunity. There are too many unknowns, plus there is the possibility I am devoting my research time to the wrong group of equities – my research simply didn’t have enough time to screen all the candidates in late 2008/early 2009 and thus I made some, in retrospect, sub-optimal investment decisions.

One of the easiest ways to evoke powerful emotions in the market is by being heavily invested in cash, but watching the rest of the equity market rise without you. An example is stalking an investment candidate close to your buying point, but watching it going up without participating in any upside. There is a sense of lost opportunity, but one always has to console themselves with the fact that there will be future opportunity – just that it will be in a different security and you have to be patient.

Have recent buyers in the past few months been the type of people that sold out in 2009 and didn’t participate in the massive gains subsequent to the economic crisis? Have these people been getting back into the market in droves? Equity and fixed income markets would suggest this is the case.

Patient I will be. The worst mistake that can be made is by forcing your cash to work in sub-optimal investments. The cash earns a small yield, but at least it is a positive and not negative number.

The first few days of November

The big looming issue is the US Congressional Elections. Since the actions of the US government have a heavy influence in the marketplace (e.g. raising taxes), I will be taking a break and watching the show. Expect posting to be light for the next couple days.

Almost all the pundits are predicting the Democratic party will be losing control of the US House of Representatives, and possibly the Senate, but either way this will mean gridlock for the US government – something traditionally favourable to the market since it is difficult for a split government to implement rule changes that increase risk.

Inflation and the markets

There hasn’t been too much going on in the markets – the undercurrents feel very swift, however. There is the specter of the looming currency wars, which seems to be the 21st century version of trade protectionism – where all currencies have a race to the bottom.

This is likely to result in the increase in commodity prices, and we are already seeing this in items like sugar, grain, etc. Increased commodity prices is the first step in the erosion of purchasing power of cash.

Whether the statistics are reported by the consumer price index or not is irrelevant – it is clear that the purchasing power of currency is dropping, more than what most people perceive. Not helping matters is very loose monetary policy, where institutions can borrow money for very low rates and then lend it long – this inflates asset prices as capital searches for yield.

The games that sovereign governments are playing are only going to accelerate as debt loads continue to increase – there is no way, for example, that the USA has a reasonable chance of balancing its books, or even paying off the debt without a massive restructuring. The least painful and least politically costly way of doing this is to inflate the currency.

Both retail and institutional investors have to be very cautious that the game with currencies and asset values will result in a lot of pain for all involved, as it will accelerate market volatility. The only apparent escape is to purchase assets that have a claim to cash flows derived from an inescapable consumer need, such as fuel or food. Even in those two cases, you have to purchase a future claim to a cash flow at an acceptable price, which is ever fleeting in today’s marketplace.

It is ironic that the best claims to future cash flows I have found are in non-dividend or very low-dividend bearing securities. Almost anything giving off cash has been bidded up to unacceptable levels.

The only argument against all of this is that you would suspect that government bond yields would be increasing when the markets sense such “stealth” inflation is occurring, but this has not happened yet due to the federal reserve’s quantitative easing program, which has created an asset bubble.

Pay attention to index volatility

Now that Canadians are recovering from their Thanksgiving turkey dinners, it is time to pay attention to the marketplace once again.

One chart I will bring to your attention is the volatility index, VIX. It measures the implied volatility of the S&P 500 index. It is also equated with being the “fear index”. Implied volatility of the marketplace is highest during market crashes.

Historically, when the VIX goes under 18, it does not bode well for the marketplace – it’s a good rule of thumb (the lower the better) to watch out for complacency. Obviously since VIX is not a predictive index, you should not base your outlook on it, but it does convey the information that market participants are not betting on a crash (or a spike up) in the near term.

Traders that expect some form of volatility can bet on both sides of the marketplace – by purchasing a call and a put at a strike price, they will win if the market goes up or down a certain quantity. For example, right now with the S&P 500 at 1164, you can purchase a December expiry (December 17, 2010) call and a put, with a breakeven point of 7% movement (roughly 40 points in either direction). Conversely, you can profit if you sell the same options and the market does not move further than 7%.

Playing options are very difficult since you are fighting very good mathematical models, so I do not recommend them for casual investors. Most option-based literature I’ve found makes it sound like an easy game, but it is truly not. The only thing worse than playing a very difficult game is being mislead into thinking that the game you are playing is easy. This goes for the stock market in general, but especially option trading.