Volatility Squared

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Sally Limantour

Carry traders are in an option buying frenzy with implied volatility on a 1-month dollar-yen option moving to its highest level since Aug. Some are predicting a 10% move by month end. As mentioned here these last two weeks, volatility was a screaming buy in many asset classes – not just stocks and the VIX. Meanwhile, the 30-day statistical volatility of the volatility indices more than doubled overnight!

Yesterday’s Chicago purchasing manager’s Index for Feb. came in at 48.7 and anything under 50 is not particularly healthy. In addition inventories rose sharply to 54.5 from 41.9 which is bothersome as is the new home sales number in January, which fell 16.6%. With the medium/long term models still on a sell signal from last week and the short term model on a sell from Tuesday morning, my view remains the same as Monday – continued weakness with increased intraday volatility that will make day trading a fun job again. Witness this morning’s sharp break and rally, something nimble traders welcome. Until we get solid closes over 1429.00 in ESH7 and models turn at least neutral, I will stay defensive while taking advantage of intraday extremes.

Bernanke said he did not see a “real trigger” for the sell off on Tuesday. I wholeheartedly disagree as mentioned in, “the great unwind.” He also said he doesn’t see any real issue with liquidity. This statement is causing mixed interpretations. Some think he is communicating an ongoing “Greenspan put” (which refers to investor faith that the Fed will always combat market declines) while others think he means this is not the Greenspan Fed and we should not expect rate cuts if financial markets get wobbly. You choose, but remember it was Bernanke who in 2004 during a Q&A said, “I think it’s extraordinarily difficult for central bank to know in advance or even after the fact whether or not there’s been a bubble in an asset price.” (Note to self - watch the charts. They speak volumes without the ambiguity).

On dips, I continue to add to volatility positions in currencies and stocks and added to long positions in yen, gold and silver while moving up stops in the agricultural sector to protect profits. The metals and agricultural sectors have been outperforming and corn is up 90% since first writing about the bullish outlook.

Volatility -- My Two Cents

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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.

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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)

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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.

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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!!

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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.

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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:

http://blogs.wsj.com/marketbeat/2007/02/28/better-lucky-than-long/

Equity Index Update

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Brad Sullivan

Driving into work this morning I was listening to a local Chicago radio station when the news report came on and the pre – news conversation turned to yesterday’s decline in the equity markets. This show is anything but serious and I was struck when the star of the show said his brother was a stockbroker and how he wanted him to buy during yesterday’s decline. This prompted the news reporter to talk about how traders woke up to the Asian bloodletting yesterday and just kept on selling…but it will come back, like it always does.

Normally, on the heels of such a whipping, I reverse course and become a buyer…and I was up much of the night trading on that very theme. However, those were trades to take specific advantage of the enormous discount we settled at to fair value yesterday across the index board. That trade has played out as the indices are called to open sharply higher from settlement, but around their respective fair values. Now…things become a bit more difficult. Certainly, I was a bit surprised to hear such complacent talk after a -4% decline on the morning radio. Could this be a sign that there is more to come on the downside?

It is worth noting that the SP minis traded a whopping 3.5 million contracts in yesterday’s action…that equates to the single largest volume session in this contract's history by nearly 50%. In addition the volatility that captured the market after the much discussed computer glitch in the DJIA calculations seemed to catch everybody searching for answers. There is no question that the move was heart wrenching to the downside, but after watching Cramerica last night, I have to wonder if there is not just a little too much cheerleading and explanation of the decline for there to not be more – and potentially much more behind this downdraft. I remain steadfast that this move picked up acceleration with the strong drop in Yen/Dollar and the unwinding of the infamous Carry Trade. As I write this…the Yen is rallying to highs for the session vs. the Dollar and the index market is buckling. It is and will continue to be the number one indicator in my book moving forward.

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As for the session today…expect HEAVY doses of volatility and whatever you do…don’t get caught selling bottoms and buying tops because the reversals are lurking behind every tick. I suspect we will have an inside session…most likely inside the final two hours of trading from yesterday. Keep in mind that there will be lots of gunslingers hitting the trade today…utilize a strong plan to stay out of trouble.

Volatility Revisited

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Sally Limantour

The wave of risk aversion for most global equities finally broke yesterday as
rumors of a government crackdown in China on buying stocks with borrowed money and other dubious practices took hold. In our own backyard the continued concerns of higher margin debt, sub prime mortgage loans and geopolitical concerns now conspired to create fear. Up until today markets were so complacent that financial market contagion appeared to be a thing of the past. This complacency could be seen in the extraordinary absence of volatility that has been a defining feature of financial markets.
I wrote about this on 02/07/2007 stating that I was initiating long volatility strategies.

With stocks markets down sharply and exacerbated by problems calculating the DJIA index, stocks had one of its worse days in history falling over 540 points around 3:00 pm. Not all charts were plummeting however as the VIX, the CBOE volatility index shot up like a rocket closing up 64.22%. This was an unusual spike as looking back since the VIX was first introduced in 1993 there have been only 4 days in which the VIX spiked up 30% or more. It is interesting to note that the VIX has not made a 40% move to the upside since February 2, 1994 when the Fed shocked the market with its decision to raise interest rates.

This dramatic move up in the VIX still has the index at relatively low levels. Consider past events - in March 2003 when people thought the insurance sector was about to implode the VIX traded above 30. During the summer of 2002 when the telecom sector was threatening the VIX traded above 40.

So the question now is with the VIX closing at 18.31 does this mean the index is heading higher and stocks lower? Currently we are moving up from very low levels in the VIX so the percentage move up in one day is extreme. Markets revert to the mean (each way) so I would expect a short covering rally in stocks and a correction in the VIX back to lower levels in the short term. Typically VIX spikes last for a day and retrace on the second day.

Going forward, given that the market’s persistent and long running appetite for risk I expect volatility to trend higher and stocks lower in the weeks ahead. Also, my global volatility indicator that measures over a hundred global financial assets still remains at a low level and is far from signaling a buy on global stock markets. As mentioned on the post here on 2/12/07 (S&P and Currencies) my medium and long term model were warning of a “high wave risk aversion” (meaning a sell signal) and I was concerned about the unwinding of the carry trade and mentioned “we could see a bear trap rally in the yen.” All of this could lead to what was referred to in a FT article, “The Great Unwind is Coming.”

I will add that with the creative financial engineering we have witnessed leading to highly leveraged derivative strategies it is difficult to assess where real liquidity begins and leverage ends. This is something we will find out in the weeks ahead.

Equity Index Update

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Brad Sullivan

This morning the indices are trading sharply lower on the heels of a mini-crash in China where the market lost -9% of its value in their Tuesday session. In addition, the unwinding of the Yen Carry Trade has begun in earnest as the YEN is higher by +1.2% vs. the Dollar overnight. I have said for quite sometime that this is the key, the liquidity primer that has become one of the primary reasons for the decrease in global volatility. Now…if this Carry trade turns into a fiasco of “last one turn out the lights” it will have major negative implications across the global index and commodity markets.

Given that I have laid out the bear case, it is worth noting a couple of key points. IF THE YEN CARRY UNWINDING IS MODERATE IN NATURE, the markets should have little trouble adjusting to this liquidity squeeze. On the flip side…all one needs to do is examine a chart from last years steep selling in the index market --- REMEMBER IT ALL BEGAN WHEN THE YEN RALLIED SHARPLY VERSUS THE DOLLAR ON COMMENTS OUT OF THE BOJ REGARDING THE END OF THE EASING CYCLE. Granted, the subsequent rally was tremendous and has carried the indices to new trading highs. However, being a short term trader we are concerning ourselves with the outlier event…and that is volatility. If I am correct, I suspect that today will usher in a several week period of increased volatility - time to put away the sunscreen or ski boots.

As volatility begins to come back into the marketplace, it will widen the true depth within the bid/ask. We have grown accustom to size up at every tick in the index futures markets – this will subside as market maker programs adjust for the uptick in volatility. Subsequently, this will increase the impact a large order has on the market – for example, an order to sell 1500 sp minis at the market during a liquid time of day may only move the index a couple of ticks. Today, that same order could move the market as much as 1.75. Be prepared for strong program playing and liquidation. In addition, be ready for some quick and aggressive short covering moves.

Risk Aversion Behavior

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Sally Limantour

The biggest news today is the 9% collapse in China’s share prices. The People’s Bank of China’s decision to raise the discount rate one more time in the day prior to the Lunar New Year is piercing the bubble in what is the largest sell off in more than a decade.
We are coming into the market with this spreading globally and the S&P down .93% and the NQ down 1.66%. The mini S&P just went through the support level I mentioned on my 12/23/07 update of 1440.00. We also had a very weak durable goods number this morning coupled with the Greenspan “R” word in our collective psyche’s, the sub prime worries and geopolitical concerns.

Earlier this month Mr. Cheng Siwei, the Vice Chairman of the National People’s Congress, said the speculative rise in share prices was a “bubble” and that investors need to be concerned about the risks in the stock market.

In the FT he said, “In a bull market people will invest relatively irrationally. Every investor thinks they can win. But many will end up losing.That is their risk and their choice.” The question on everyone’s mind this morning is whether the liquidity spigot will turn to a slow drip as huge capital inflows from China has allowed excess capital to move globally propping up stock markets everywhere. Or… to we do what has been working for so long which is to buy the breaks.

This morning has the taste of fear and liquidation. My first good support in ESH7 comes in at 1229.50. As mentioned yesterday, after having my shortest term model on a sell for a week, it went back to long and many people emailed asking how to I use this model. I use it for day trading only- no overnight positions in this timeframe. If it is flashing a sell, I tend to be more aggressive on selling during the day. If it is in a buy mode, I will more actively pursue the long side on breaks which is what I did yesterday. All last week, starting on Friday Feb 16th, the sell signal was predominant so my strategy was to sell rallies until yesterday. Coming in today on this short term model I am flat and it has turned back to the sell mode.
This does not mean to come in and sell the ESH7 at the open, but to watch and see if there will be any good intraday opportunities to go short. Obviously as a day trader I may pursue the long side on a sharp spike down to that 1429.00 area, but will see how the day unfolds.

Given the current risk aversion playing out across global equity markets coupled with my medium term indicators warning of a high probability of risk aversion behavior this is not a time to be buying dips aggressively and holding in my opinion. We have had a one way market for most global equities since June/July 2006 and the cracks are starting to appear.
Long volatility positions in the stock indices mentioned weeks ago were established as a way to capture a potential wave of risk aversion for the next few months.

Going forward should this turn into a more meaningful sell off we have to assess how this will carry into other asset classes that have benefited from
this global infusion of capital, such as the commodity sector. The metals are taking a hit from this as is the dollar. Bonds, however are benefiting from this and exhibiting the flight to quality behavior as we approach key resistance levels in the June bonds of 112.20-113.00. Currently, I am holding off on short positions in bonds and tightening stops on most commodity long positions.

S&P and Commodity Prices

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Sally Limantour

The S&P had a small loss last week falling 0.25% with concerns over the sub prime lenders, rising inflation and geopolitical issues in the Middle East. Friday’s reading on the put to call ratio was its highest since September ’06 as investors put in place considerable downside protection against a much anticipated sell-off. My shortest term model covered shorts on Friday and is now on a short term buy signal. Perhaps we will see a near term short squeeze. Holding above the 1454 – 1456.00 (ESH mini- S&P) is supportive and recapturing the 1462 could ignite another round of fresh buying.

Today in what would be the largest private equity buy-out on record we have news that the board of TXU, the largest power producer in Texas met to approve a 45bn (IHT reports it is a $32bn deal while FT reports $45bn) takeover by Kohlberg Kravis Roberts and Texas Pacific Group. Part of the agreement is to sharply scale back TXU’s $10bn plan to build 11 new coal fired power plants that would produce noxious greenhouse gas emissions.
Everything is green – Al Gore, the Oscars and corporate America.

Commodities rose across the board lead by precious and base metals, crude oil and grains. Crude oil is now up 4.6% for the month with gold up 4.4%, corn up 6.6% and nickel up 12.3%. Even Jim Cramer is getting nervous about gold prices saying that higher prices could be “kryptonite to stocks if it goes to $710-$720.

It is a broad based rally in the commodity sector which is healthy, but it is stoking the inflationary fears. Treasury inflation-protected securities, or TIPS, have returned 1.15% so far this year, versus a loss of 0.3% last year. Investors are hedging their bets as inflation remains a “predominant concern” for the Fed. Higher commodity prices seep into everything – even beer! FT reports, “Blow for beer as biofuels clean out barley.” The demand for biofuel feedstocks such as corn, rapeseed and soybeans is encouraging farmers to plant these crops instead of grains, like barley. Heineken warned last week that the expansion of the biofuel sector was beginning to cause a “structural shift” in European and US agricultural markets.

While I have read a few articles claiming the commodity sector is running out of steam, I think it is beginning another leg up in its bull market. Billions of new people are entering the market and like all human beings, they want to move up the food chain, not down.