Wednesday, February 28, 2007

Volatility -- My Two Cents

Volatility -- My Two CentsSocialTwist Tell-a-Friend
Fari Hamzei

We have enjoyed a Low Vol environment fueled by tremendous global liquidity that began approximately about a week before Gen. Tommy Franks commenced his precision air campaign to get rid of Saddam Hussein's atrocious regime. This coiled-up Un-Vol got adjusted yesterday. It always does. In all cases, we revert back to the mean, after a strong retest. To put it all in proper perspective here are some sigma channel charts:

On October 27, 1997, the DOW dropped 554 pts, SPX dropped 65 handles (-6.9%) while VIX went from 23.17 to 31.12 (up 34%) which made VIX hit its +4 sigma channel (63.34 per million probability of occurrence) if one assumes options prices are normally distributed – after all VIX is a multi-way MIV calculation of SPX options. The following day, one of the greatest speculators of all times, the legendary statistical anomaly trader Victor Niederhoffer, closed all of his funds.

In August thru Oct 98, leading to the LTCM debacle, when some of Wall Street’s best and brightest went bankrupt, the big VIX day was on Monday Aug 31st. Dow was halted after 550 pts drop, SPX dropped -6.8% for the day and yet VIX only went from 39.6 to 44 (11%) and sigma channels chart shows it hit its +2 sigma and change area (1.24% probability of occurrence)

During a more recent market sell-off, on April 15, 2005, VIX went above its +3 sigma channel, as the SPX sold off -1.64%;

and on May 15, 2006, after a two-day SPX rapid sell off of 31 pts, VIX only hit +4 sigma.

Yesterday, we saw a 6 sigma channel move in VIX. This was truly an extraordinary event. DOW dropped 416 pts, or 3.3% (max drawdown was -546 pts) -- SPX dropped 50 handles or -3.47% and VIX shot up 64% and hit its 6 sigma (1.973 per billion probability of occurrence).

And for comparison only, here is yesterday's VXN chart (NDX Vol Index) -- notice it only hit +4 Sigma yesterday!!

Bottom line – the big question is what are we in for in the near future ??

The Vol will come back to the norm very rapidly. It always does. In my book, this was a China event. In the long run, it is good for all of us, as painful as the next few days may be, as Chinese financial systems enter 20th Century by western standards.

US Economy is strong, liquidity is ample, and thanks to Secretary of Treasury and former Chairman/CEO of Goldman Sachs Group, Hank Paulson, we have a rejuvenated PPT and as Uncle Ben testified this am, “the Working Group is monitoring the markets very closely.” Once we go thru the vol retest and the forgetting rate kicks in our collective brains, we will resume the “normal course” again. A Six-Sigma Event is never normal.

In the near future, the Inflation, Gold and Crude Oil will come back. So would be the Stocks and the ETFs. We just have to work this hemorrhage out of our system.

One of our professional traders was quoted today in Wall Street Journal's Market Beat Blog on using our Dollar-Weighted Put/Call Ratios to get short last Thursday. Click here for more details:

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