-- Posted Tuesday, 15 August 2006 | Digg This Article
| Source: GoldSeek.com
Rick's Picks
Tuesday, August 15, 2006
For investors who'd rather be smart than lucky
Mark Klizas is a trader, a seasoned technician and former colleague of mine from the floor of the Pacific Stock Exchange. Below, he shares some observations concerning the Volatility Index (VIX) that could open the door for us as traders. Mark thinks volatility is a buy at these levels, and here's why:
"[Rick's Picks] readers have been kept well informed of the significant risks in the economy, the world situation and the stock market. As we are about to enter the seasonally weakest time period for stocks, traders are looking for strategies to capture the opportunities of these tumultuous times. The most tempting strategy to maximize profit in a sharp market decline is to buy puts on equities or derivative products. The problem with a naked put strategy is that one has to be very good with timing as well as direction, or it can become quite costly. There is a relatively new product, options and futures on the CBOE volatility index (VIX), that could provide similar profit potential, but with considerably less risk from adverse timing and price action.
Portfolio Insurance
"The VIX has been around for many years as an information tool. It is often looked at as a barometer of the cost of portfolio insurance. It trades low during periods of complacency and high when market risk is perceived as being elevated. It used to measure the implied volatility of a representative basket of options in the OEX. The CBOE recently retooled the VIX to measure the implied volatility of near term (one and two month out) option series in the S&P 500 index (SPX). VIX futures were introduced in 2004 and cash settled options began trading in February 2006. Traders now have a direct way of trading the implied volatility in the market. I believe the recent, near historic, lows registered in the VIX near the 10 level will not be seen again for some time. The increasing intraday volatility we have witnessed of late should soon translate into the daily and weekly charts and move the VIX upward. A significant market correction this fall, a likely occurrence in my view, should accelerate the process.
"As you can see from the following chart of the VXO (the old OEX based VIX used for older historical data), the VIX has a very strong inverse correlation to the direction of stocks.
"During the recent 8% drop in the SPX, the VIX more than doubled from around 11 to just shy of 24. In fact, over the past decade, the VIX has spiked up [during market declines] by 10 or more points on 24 occasions. Eight of those spikes exceeded 20 points and 5 times they exceeded 30 points. It doesn't take much imagination to see the profit potential of getting long this index in the teens if we are in the early stages of increasing market volatility. The stage is set for an increase in base VIX levels toward historical norms in the 20's with spikes into the 30's or higher in the not too distant future.
Clues from1990s
"What will happen to the VIX if the market continues to rally from these levels? A look at the chart from the mid 1990's provides some clues. After a year of steady gains in 1995 without a single significant correction the VIX ended the year near its low around 10. The market continued to rally over the next several years, but with occasional corrections along the way. These were the "irrational exuberance" years that Alan Greenspan warned about, and the VIX chart echoed those concerns as each successive VIX rally (market correction) was met by a higher base that reached the 20 level by 1998. The recent action in 2006 looks similar to the break off the base in 1996. Could market participants be expressing their concerns by raising insurance premiums against equity purchases. While a market decline would be most profitable for a long VIX position, a market rally poses less risk than a similar short market position in equity-based futures or options.
"VIX options are European exercise (they cannot be exercised early), and therefore often trade at a discount to parity at times of market spikes. One must understand this and be willing to sell deep in the money calls at a discount to lock in profits at panic bottoms. They also offer the opportunity to purchase discounted calls part way through a big market move. Expirations are on the Wednesday before or after the traditional options expiration, depending on the month.
Autumn Risk
"Even if one does not trade the VIX, the pricing of the options relative to the underlying index can provide useful clues to market sentiment. During the market decline in mid June, the near term VIX calls were deeply discounted until right before the market bottom when they bid them up to near parity. The discount to parity must have looked enticing to those who came late to the party. As usual, that's about the time the music stops. Currently, the November calls are well bid, indicating others are concerned about market risk going into the fall. The October calls will be listed when the august series expires and should be less pricey, but should still provide coverage for most of the fall volatility season. Happy trading."
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Information and commentary contained herein comes from sources believed to be reliable, but this cannot be guaranteed. Past performance should not be construed as an indicator of future results, so let the buyer beware. Rick's Picks does not provide investment advice to individuals, nor act as an investment advisor, nor individually advocate the purchase or sale of any security or investment. From time to time, its editor may hold positions in i ssues referred to in this service, and he may alter or augment them at any time. Investments recommended herein should be made only after consulting with your investment advisor, and only after reviewing the prospectus or financial statements of the company. Rick's Picks reserves the right to use e-mail endorsements and/or profit claims from its subscribers for marketing purposes. All names will be kept anonymous and only subscribers' initials will be used unless expre ss written permission has been granted to the contrary. All Contents © 2006, Rick Ackerman. All Rights Reserved.
-- Posted Tuesday, 15 August 2006 | Digg This Article | Source: GoldSeek.com
