Vix, Valuable or Valueless
"It is not death that a man should fear, but he should fear never beginning to live." - Marcus Aurelius 121-80 AD, Roman Emperor, Philosopher
VIX is a weighted measure of the volatility for eight OEX put and call options. The eight puts and calls are weighted according to the time remaining and the degree to which they are in- or out-of-the-money. The result forms a composite hypothetical option that is at-the-money and has 30 days to expiration. VIX represents the implied volatility for this hypothetical at-the-money OEX option. Typically, VIX has an inverse relationship to the market, which means that a rising stock market is viewed as less risky and a declining stock market more risky. The higher the perceived risk is in stocks, the higher the implied volatility and the more expensive the associated options, especially puts. Hence, implied volatility is not about the size of the price swings, but rather the implied risk associated with the stock market. When the market declines, the demand for puts usually increases. Increased demand means higher put prices and higher implied volatilities. http://www.investopedia.com/terms/v/vix.asp
We were one of the first to state that this indicator had lost its value because the masses were following it to closely. It became popular after CNBC started talking about it on a regular basis last year. At that point we stated that the VIX was going to head to even lower levels and completely lose its effectiveness.
To date we have been more or less correct. To bring things into perspective lets examine two dates; Oct 2003 the VIX was close to 60 and now February 2005 it's at 11.59. If we were at this level a year ago all the market pundits would be bellowing that the world was about to end. However they are not coming out in full force and that's why we are paying a little bit more attention to this indicator than we normally would.
It also just put in a new 8-year low (actually this a historical low). We only pay attention to indicators used by the masses when they give of extreme readings. This serves as another confirmation that we should see some sort of pull back that will drive quite a bit of fear into the masses in the short-term time frames. This data might seem to be conflict with last week's data, which stated that the bulls were now at their lowest levels ever. Do not let this throw you off track, to many people are still paying attention to the VIX for it to be fully effective. Its only going to work when extreme readings are given off and then only for a brief period of time.
Our main point here is to show that the masses by nature can only lose and that when they start to use a specific indicator or TA tool its time to dump them ASAP. Eventually they will get tired of it and let it go, that's when you can come back and use as its accuracy will dramatically improve.
Based on trend line rules, we usually need to see a minimum of 3 down trend lines before some sort of long-term reversal is in the works. Looking at the above graph we can see that we still have quite a bit of time before a third down trend line can be drawn in. This means that longer term there still appears to be a decent amount of upside potential left in this market. The markets do however need to undergo a nice healthy pull back first.
One should never rely on just one or two indicators to time their entries or exits. One should always be looking for new indicators that are falling out of favour with the masses to latch onto. It's just like investing in a new sector; the big money is made before the masses jump in. A few good examples are the Gold, Silver, Oil, Nanotechnology etc. once the masses jump in the sector or sectors take off and the only ones that make money were the ones who took position early and waited patiently. It's the same with indicators, as soon as they are in favour they lose their value and vice versa. The tricky part is to be able to spot this subtle change in its early stages.
"I have always felt that although someone may defeat me, and I strike out in a ball game, the pitcher on the particular day was the best player. But I know when I see him again; I'm going to be ready for his curve ball. Failure is a part of success. There is no such thing as a bed of roses all your life. But failure will never stand in the way of success if you learn from it." - Hank Aaron 1934-, American Baseball Player
Is the VIX a load of Blarney?
By John Tyler
An Irish Bard wrote:
"There is a stone there,
That whoever kisses,
Oh, he never misses,
To grow eloquent,
'Tis he may clamber,
To a lady's chamber,
Or become a member
The VIX has been imbued with the same power as the Blarney Stone. It is probably equally effective these days in signalling significant market moves.
Ask yourself a question:
Would you rather go and kiss the stone in person or see a brochure of a terrified tourist clinging over a massive drop as they try and kiss the Blarney?
I think that most would agree that the actual experience is more fulfilling.
How about market volatility? Can you kiss the actual stone that imparts magic? Using the VIX is like using a tourist brochure because it is a mere distorted image of reality.
Volatility is a real measure of market activity, just as price, volume and time are. However the VIX is implied volatility of options, and while giving some useful information about options, is several steps away from the actual market.
To experience the real market and get the most useful information, you need to get as close to the market as possible. To kiss the Blarney stone so to speak.
We have realized the problems with using the vix for some years now, and instead use the average true range of the price as a volatility measure. It's too simple for many, but having looked at it with over 100 years of data, it has providing a longstanding and useful source of information on market dynamics. When set up as an indicator, it is useful in both weekly and daily time frames, as well as long and short term trends.
The following examples are drawn from weekly charts, with a 14 day average of the true range being plotted in the upper window:
Example 1: Dow Jones Industrials 1900- 1901
We see the 1900 peak being accompanied by a negative divergence in the average true range – volatility is falling. We then see this increase to a new peak as the trend accelerates downwards. Volatility increased.
Example 2: S & P 500 1950-1951 shows what is an unusual pattern in the
historical context. Unlike the VIX, the average true range has a long history
that we can make use of.
The first pair of red arrows shows a cyclic low with a flattening of the average true range, or a fall in volatility before an important run up.
The next set of arrows show a negative divergence at a market top, like with the earlier Dow example.
Example 3: S &P 500 2004- 2005
I will be spending several hours this weekend going over 100 years of charts to look at the historical precedents. They are few and far between.
However simple, I will trust the average true range much more than the VIX. It is a direct reading of market volatility with an extensive history that can be referred to. This provides a most useful help in these interesting times!
John Tyler with sweaty palms and chaffed lips, wondering if the magic of the stone will work ......
John Tyler, CEO