Option trading in the United States has decreased 23 percent compared to October (see Bloomberg article). During market moves, it would normally seem to make sense that market moves might cause increased option activity as investors look to protect their equity investments, but rapid sell-offs (and subsequent rallies) have resulted in higher volatility, driving option premiums higher. While higher option premiums may be prohibiting some traders from being able to efficiently use options for hedging, the root cause may be with the equity trading itself. Regardless of its impact on option premiums, the increased trading has reduced the number of equity trades for those who typically hedge such positions, thereby reducing the need for hedging with options. As hedge funds get smaller, their impact on trading (currently about one-third of all trading) will also decrease, reducing volume, and putting further pressure on liquidity. As traders search for a market bottom, they may be misleading themselves. We could simply be looking at a type of mean reversion to a pre-hedge-fund-explosion market with regard to asset prices and trading volumes. Current levels may be less about bottom building, and more about new market norms. Of course, this means reversion from the mean could take us into seemingly scary territory in the near future as the market recalibrates to a new post-irrational-exuberance world.
Selling by hedge funds is still putting pressure on the market (see WSJ article). As we have discussed over the last month (see posts here and here), many redemption requests by hedge fund investors are now meeting their waiting periods, causing many funds to sell assets in order to raise cash. As quoted by Gregory Horn, president of Persimmon Capital Management:
"In mid-October, redemption levels were in the 5% range but all of a sudden now it's cranking up to as high as 25% for some funds."Certainly not good news for hedge funds, but maybe even worse news for the market. With continued forced selling, it is unlikely the market will quit trying to find a bottom. Hedge funds will continue to sell every rally, increasing volatility. As long as the VIX continues to spike and stay at elevated levels, and we continue to see the "punch-in-the-stomach" late day sell-offs after nice rallies (both of which I suspect are indications of further hedge funds selling), we will continue to be in a volatile holding pattern between 850 and 1,000 on the S&P. Unfortunately, it is difficult to know exactly when the selling will quit, as the selling and redemption requests are tied together in what is becoming a volatile catch-22 pattern that is feeding upon itself. The other day I heard an analysts say it was "too late to sell, but too soon to buy." Until hedge fund investors believe the former, it is unlikely any investors will quit believing the latter.
Banks are continuing to ask for more collateral to back past hedge fund lending, causing more funds to liquidate their positions (see WSJ article). When added with investor redemption, bank-induced liquidation is forcing hedge funds to step-up their deleveraging. Such selling is continuing to put pressure on the market, generating more requests for bank collateral and investor redemption, in what amounts to a catch-22 that continues to spiral the market downward. Such selling has been occurring for a while, as funds have been unwinding exposure to financial and energy stocks, both of which continue to suffer as crude oil continues to drop, and the credit crisis continues to unfold. While Hedge Fund Research recently reported that the level of hedge fund market exposure has decreased by one-third over the last year, I suspect that this still may not be enough. As mentioned by Antonio Munoz-Sune, head of the U.S. for fund of funds EIM: "The combination can take anyone down." Unfortunately, it is difficult to tell where we are in the hedge fund closing and deleveraging process, with many hedge funds still appearing to use every rally as an opportunity to sell. I suspect that until we see the VIX approach more normal sub-30 levels, stop seeing the DJIA and S&P 500 Index post intra-day percent swings in the high single digits, and see crude oil stop falling in price, it is unlikely that the market will stop feeling the effects of hedge fund selling, allowing for a long-term and lasting rally. Like most bottoms, we won't know for sure that it has occurred until we see it in the rear-view mirror, but I will be watching the VIX, the price of crude oil, and the Dow Jones and S&P 500 index percent swings for clues.
In an attempt to profit from the recent increases in volatility, an ex-Merrill Lynch trader is planning to start a volatility hedge fund (see Bloomberg article). The fund will try to profit by buying and selling option contracts linked to currencies, commodities, and global equities. Year-to-date, volatility funds are up 7.3 percent (see previous post), allowing them to outperforming other hedge funds. The trend in offering such funds seems to be increasing given that earlier this month CQS launched a Global Volatility Fund (see previous post), and other new funds are also raising capital. The new proposed funds are also coming at a time when the VIX has recently rose to its highest value since 2002. Could this be a contrarian signal, indicating lower volatility going forward? Possibly, but given new regulations and changing market rules, it is likely that volatility levels will be elevated for the foreseeable future.
Year-to-date, volatility hedge funds rose 7.3 percent according to data from the Newedge Volatility Trading Index (see Bloomberg article). The average equity fund fell 8.38 percent during the same time. Corporate fixed-income funds declined 4.00 percent YTD, and energy and basic- materials stock funds are down 6.36 percent over the same time frame. The 50 or so hedge funds that investing in volatility have been able to profit from the swings caused by the subprime and Fannie/Freddie news without trying to pick a direction for the market. New funds focusing on volatility are continuing to be developed nearly everyday (see previous post). This year the S&P 500 has fluctuated by more than 1 percent on 71 trading days, making this the most volatile start since 2003 and surpassing the 61 day annual average since 1928. The index is on pace to have its most volatile year since 2002, a time when there were 125 swings of more than 1 percent. The CBOE Volatility Index (VIX) also reached a five year high of 32.24 on March 17 of this year (the day after the Bear Stearns bailout), and has been 33 percent higher than in 2007, averaging 23.12 this year. Some analysts are expecting elevated volatility for the next couple of years. Nonetheless, even if volatility remains above historic levels, it is worth noting that the VIX has fallen 31 percent from its five-year high in March. As such, it appears that even trading volatility can be a volatile (and risky) move.
There is a article worth reading at the MarketSci Blog about how the VIX may not be as magical as some make it out to be. The blog post is responding to another on the subject written by Mark Hulbert, whose opinion I agree with on this subject. BTW, the article is also discussed at the Daily Options Report, and there is a good exchange of comments with Bill Luby at the VIX and More site (also worth the read, as usual). The article does a pretty good job illustrating how the VIX is like any other indicator - it is just another tool in the toolbox, albeit useful and better than some.
While the VIX is based on a somewhat complex algorithm of implied volatility, it is not a perfect model in the strict sense of the term for how it is being used in that it has not been fine tuned with the optimal parameters or the best inputs in order to measure something other than, as discussed by Hulbert, "... the volatility that options traders are expecting the stock market to experience over the subsequent 30 days." The fact that we use the market sentiment implications of the VIX for timing market turning points, or by assigning relatively arbitrary benchmarks (like the market will rally when the VIX is above 30), makes it no more or no less a better indicator in my opinion, or more importantly, a specific model for the purpose we are using it for. Assigning a heuristic is helpful in that it starts to get us interested, but it does not make it any more predictive.
Like many indicators, the VIX may be just another way to measure an oversold market. Helpful, yes, and something I look at, but it should not come as any surprise that it is not anymore accurate than 3/4th of the time, and even then, timing is not exact. In fact, if it was nearly 100% accurate, with good timing, then I would not be writing this article, and you would not be reading it. Instead, a few lucky traders who spotted it first would be sitting on a private island somewhere, while a second group sometime later would have made a some money and garnered some fame writing about its use (with some nice historical relationships provided as support). Meanwhile, the indicator's predictive ability would have probably self-destructed, causing the rest of us to end up disappointed as its widespread use has now caused the indicator to simply tell us what we already know ........ while nicely giving us approximately 3/4th direction accuracy with less than perfect market timing.
Again, please keep in mind that I am not saying the VIX is useless. I look at it everyday, and find that when it starts spiking I need to start paying attention a little more to what is occurring in the market. My issues are from two areas: 1.) assuming that once it reaches a benchmark (30 for most), something is going to happen soon; and 2.) from taking something that was not really designed for how it is being used (market timing), adding a heuristic or two, and then assuming it is a model to be trusted. Rightly so, none of the authors mentioned and linked to in the article states this, or puts absolute faith in heuristic turning points. Like them, I believe the VIX is a good tool in the toolbox, as long as your toolbox contains more than one hammer, and as long as you are convinced that not everything is a nail.
There has been a lot of anticipation recently as to when the VIX would finally spike back into the 30's. Recent moves above 30 in November, January, and March have produced temporary bottoms, although the November and January relief rallies were short lived, and the March rally rolled over 2 months later. The VIX briefly touched into the 30's last week, but quickly corrected back into the mid-20's. Some are arguing that not only was the recent move into the 30's too short, but a confirmation spike probably needs to now be in the mid-30's (if the old rules-of-thumb don't work, try another).
Given the recent market action, it appears that more than changes in market sentiment are necessary to reverse the current bear market. Others have recently mentioned that even with the bullish market sentiment indicators, the cycle of news flow probably needs to change before we see a strong, longer-term rally. The recent pullback in the VIX, after briefly touching above 30, also has some wondering if fear has been vanquished from the markets. As mentioned before, I believe that the recent SEC actions explain some of the current moves, and that crude oil is still the main story and will continue to determined whether the market will hold any rally or reverse. The market is still at such a tenuous position that reports of continued breakdowns in diplomatic discussion or slight disruptions in the supply/demand balance will be enough to spike crude prices and send the market to new short-term highs and lows. Given the upcoming weekly economic data on crude oil inventory levels, the leading indicators number, existing and new home sales, durable goods orders, and revisions on consumer sentiment, it should once again be an interesting week.
The Chicago Board Options Exchange has introduced a Crude Oil Volatility Index (OVX), similar to the CBOE VIX which tracks volatility and fear in the stock market. The contracts have 30 day contract durations and allow traders to profit from oil trading in both directions. The OVX holds near-term futures contracts and cash to compute the level of volatility in the West Texas Intermediate crude markets. Should you trade it? As John Carter from Trade the Markets was recently quoted in a CNBC article: "I wouldn't see a lot of applications for the retail investor unless they're a little more sophisticated." Good advice indeed. It is also interesting how these types of vehicles seem to come out just as the markets they are taping into are topping or rolling over. Makes you wonder - but that is a discussion for another day. Adam Warner over at the Daily Options Report also had a nice post a few months back about using the VIX, but not trading it, since it is a derivative of a derivative. Furthermore, with retail VIX trading the guy on the other side of the trade probably knows more than you do. The post is still worth a read. Check it out.
The old Chinese proverb (with English translation) of "May You Live In Interesting Times" certainly seems to be the case for financial companies and those affected by the credit crisis (which is just about all of us). Even just a quick review and read of the financial/investment news sites gives the following:
International Herald Tribune discussing problems with Citigroup and the financial industry in general. Meredith Whitney is also quoted as staying "There is no place to hide for them." It is felt that Citigroup is so big that they are exposed to nearly everything.
New York Times article continuing to discuss how gas and food prices are pushing up inflation.
London Times Online discussing how share prices fell on the London markets after news of historic drops in home prices, and inaction by the Bank of England, are striking fears that Britain is in or near a recession.
London Telegraph article on how the Bank of England is essentially sitting on the side lines with regard to interest rates while they try to determine if a potential recession or out-of-control inflation is their worst problem.
WSJ article reporting an 18% drop in Q2 net income at U.S. Bancorp as it triples it provisions for credit losses.
Chicago Tribune article on how investors are fleeing suspect banks as fear mounts regarding a more widespread crisis in the banking sector.
Reuters article about how George Soros is once again predicting that this is the worst financial crisis of our lifetimes, and that Fannie and Freddie are just the beginning. Soros goes on to say that it may not get better any time soon given that the Fed Chairman is in a box with limited options.
Financial Times article about how the credit crisis is causing Australian companies to sell assets in an effort to improve their balance sheets.
Bloomberg article regarding the dollar hitting new lows versus the Euro, just as Bernanke and Paulson discuss issues with Fannie and Freddie, and the markets in general.
MarketWatch article discussing how Lehman Brothers, while not in danger of failing, may need an alliance, need to go private, or even need to be taken-over to prosper, yet it is unclear who might actually be in a position to purchase them. European companies, such as Deutsche Bank, Barclays, and HSBC as possible candidates since most U.S. companies will not be interested.
Forbes reporting how German investor confidence is at a 16 year low.
Fortune article discussing how the SEC, if it did not already have enough to worry about, now has to spend more time and effort chasing down rumors and the spreading of false information given its ability to damage financial companies, and even the entire financial system with greater ease than ever before.
Investors Business Daily article regarding inflation in the developing world, and how 2/3 of global inflation increases are coming from emerging markets - the very same markets that are hoped to out-perform other markets in the future.
..... and on and on and on.
Of course, is it enough to have bad news reported again and again, or do we need to really feel the bad news? Even a recent BusinessWeek article highlights how we still do not seem to have enough fear in the markets. While the recent sell-off has been consistent, the slope of the sell-off has not been very steep, nor displaying the types of spikes that often indicate fear and panic.
As of last week, the put/call ratios were not at the panic levels of the last year. The recent high for the 10 day CBOE total put/call ratio was 1.1, off from the recent peaks of 1.28 in March. The 30 day CBOE put/call ratio had a recent high of 1.0, compared to 1.17 in March. The 10 day equity only put/call reached 0.82, below the 1.00 level in March. The VIX is showing a little more fear, moving above 30% today for a short time, but falling back below 28% mid-day. Stronger, but not really the mid-30s spike that many traders are looking for.
Some indicators are beginning to show more fear. The latest Investor’s Intelligence poll had the bulls declining to 27.4% and bears rising to 47.3%. The bullish sentiment has not been this low since 1994. The bearish sentiment has not been this high since 1998. This gives a difference of 19.9 percentage points, the biggest bearish spread since 1994. The recent AAII poll shows 22% bulls and 55% bears, a number that is similar to March levels.
Overall, still a mixed bag, but looking better. Given the recent events and news, it does make you a little fearful (pardon the pun) about what it is going to take to get the capitulation the market is looking for. Interesting times indeed.
Nice article at the Daily Options Report about why you should not trade VIX calls as a way to trade volatility. Check out the whole article, but as a highlight:
Primarily because the guy on the other side of the trade understands them better than you do. Particularly if he is running a big derivatives portfolio with all sorts of variance risk, while you are seeing the recent VIX poundage and want to speculate that has gotten overdone. And you don't fully understand the bet you are making here. Which is absolutely nothing to be embarrassed about; it's an extremely confusing product masquarading as something not so complex.In a sense, the VIX is an estimate of the volatility of SPX options. As such, the VIX options are therefore derivatives of a derivative, making the analysis more complicated than most of us want and need to bother with. You are better off using the VIX as an indicator of overall market volatility, and then trading options on other assets off this information.
