Volatility Trading the QQQs

By: Adam Hamilton | Fri, Sep 13, 2002
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While a primary bear market is certainly fraught with peril for conventional long-term investors, it can be a glorious utopia for short-term speculators.

One of the most popular stock index speculations on the planet today swirls around the US NASDAQ index. The NASDAQ was the very nexus of speculative excess in our recently departed bubble. It was not the S&P 500 or Dow 30 that rocketed parabolic in early 2000 in the midst of a speculative mania orgy, but the NASDAQ.

Even though the NASDAQ is merely yesterday's bubble, old news, people tend to cling to the past and hope against hope that it will recover. For a vivid example of how long fantastic supercycle bubble manias can pervade a nation's psyche, next time you visit the Netherlands check out the gazillions of tulips all over the place. The insatiable Dutch zeal for tulips today can be traced back directly to the equivalent of the NASDAQ bubble of the 1630s, Holland's infamous Tulipomania!

Granted, the Dutch aren't speculating in tulip bulbs today as pure financial instruments, but the echoes of the tulip mania remain loud after bouncing down through almost four centuries of history. Just as tulips lingered in Dutch minds well after the Great Tulipomania Crash of 1637, the NASDAQ and tech stocks will most likely retain legendary status in the popular American psyche for years to come.

As the very ground zero of bubble mania speculation, the NASDAQ is by far the most volatile of all the major US indices. Greed and fear deep within market participants' hearts, the ultimate driver of short-term prices, remain extraordinarily powerful where the NASDAQ is concerned. The NASDAQ streaks higher on bear market rallies and plunges farther on their collapses than any other major index.

While long-term investors fear and loathe extreme volatility, speculators seek and crave it. Speculators thrive in chaotic environments with huge percentage swings in prices. As the remaining speculative excesses are painfully bled out of the slow-learning NASDAQ bubble investors, it remains the most volatile and alluring house in town for pure short-term speculation.

My essay this week is the third in a series on explorations of volatility as a short-term timing tool for speculators trading in various stock index speculations. A stock index speculation is simply a short-term gamble on which way a major index will head next, such as the S&P 500, Dow 30, or NASDAQ. If you are interested in digesting some of the foundational thoughts leading up to this essay, please see the first two, "Trading Volatility Bottoms" and "VIX Bounces S&P 500."

While the NASDAQ Composite index itself is not easily tradable, it does have close protégés that shadow it in lockstep. Futures players can trade NASDAQ 100 index futures and options, betting on the near-term future direction of the index. The NASDAQ 100 contains the biggest and best 100 companies on the NASDAQ. These 100 elite giants utterly dominate the NASDAQ composite and account for roughly 2/3 of its total market capitalization.

Stock traders can also trade the NASDAQ 100 in the form of the ubiquitous QQQs. QQQ is the symbol for a tracking stock designed to perfectly mimic the action of the NASDAQ 100 index. Speculators affectionately call these versatile instruments the "Triple-Qs" or "Cubes" (short for "Q-Cubed"). Trading the QQQs is an enormously popular pastime for speculators today and the Cubes often have the highest daily trading volume of all the stocks listed in the United States.

Because of the utter dominance of the NASDAQ composite by the 100 giant mega-caps of the NASDAQ 100, the QQQs are the ultimate proxy for stock speculators wishing to easily approximate trading the NASDAQ itself. Our first graph this week shows the NASDAQ composite since its bubble days overlaid with the cubes. The QQQs intimately match the volatile gyrations in the NASDAQ.

The QQQ NASDAQ Composite Proxy

For all intents and purposes, the QQQs are the NASDAQ for speculators. The cubes mirror every move of the NASDAQ composite like a shadow, offering speculators a convenient vehicle to capture the index's enormous volatility.

As the white arrow above marks, the relationship between the QQQs and the NASDAQ comp has begun to diverge a bit since early 2001. The probable reason is likely the declining dominance of the NASDAQ comp by the NASDAQ 100.

Way back in the bubble days, as we all remember, the mega-cap NASDAQ stocks were the market-darling investments. Even after the crash, in the summer of 2000, Wall Street was begging long-term investors to buy the mega-cap market-darlings, which turned out to be just about the worst possible investments at the time.

As the ongoing brutal Great Bear does its thing in annihilating speculative excesses, the elite NASDAQ 100 stocks are often falling farther in percentage terms from their ultimate tops than the average NASDAQ composite stock. Because of the hyper-valuations of the major NASDAQ 100 stocks during the mania, they had a longer way to fall than the average NASDAQ-listed company.

Even with the recently growing divergence however, the cubes remain the ultimate vehicle for stock traders interested in speculating on short-term NASDAQ trends. While we didn't include the graph, we also built one with the cubes overlaid on top of the NASDAQ 100, and the match, as expected, was absolutely perfect with zero divergence over the same time horizon.

The green and red arrow above illustrates the gaping maw of the downtrend pipe of the QQQs. Generally, especially after an apparent major bear market bounce, it is best to consider going long the cubes when they are in the lower half of their trendpipe, the green side. When they start ascending into the upper half of their trend however, speculators should start searching for optimum points to short the cubes.

Obviously with the benefit of 20/20 hindsight divining what road the cubes are traveling is easy. Unfortunately speculators do not have the luxury of knowing the future in advance when they need to deploy their capital. They have to gather imperfect information right now today, analyze it, and make an educated real-time guess about near-future index direction.

To circumvent the readily apparent inherent limitations of doing real-time analysis on imperfect information, speculators rely on other indicators to add color and depth to what is observed in current market conditions and charts. Interestingly, volatility is one of the most important primary indicators of near-future index direction.

As Warren Buffett wisely says, over the long-term the markets are a weighing machine but over the short-term they are a voting machine. Buffett is an amazing man and market genius and his wisdom in this single statement offers immense insight for stock speculators!

To paraphrase Mr. Buffett, over the long-run all that matters is valuation. For stocks, this is based on earnings, expressed in the mighty price/earnings ratio. Ultimately every publicly-traded company will regress to a long-term mean valuation (13.5x) based on what it can actually earn in operating profits for its shareholders. Long-term investors have to understand this crucial absolute market truth to achieve success.

Speculators really don't care about the long-term. All that matters is tomorrow, or a week from tomorrow, or a month from now. Buffett said short-term market action is like a voting machine. The markets do not necessarily do what they should do fundamentally over the short-term, but they instead do what most market participants want. The participants "vote" by buying and selling with their capital. Just like voting, short-term market action is a collective subjective decision and not an objective measurement of intrinsic value.

The markets are "voted" based on greed and fear. When most market players are greedy, markets tend to rally. When most market players are scared, markets tend to plunge. The key to speculation is recognizing these swings in naked greed and dark fear in order to time short-term index entry and exit points. Successful speculators sell on extreme greed and buy on horrific fear. They are the contrarians who act exactly opposite to what natural human emotional instinct is at various phases in short-term market oscillations.

As I recently discussed in "Trading Volatility Bottoms," greed and fear, while not directly measurable, are distilled down into volatility. Markets tend to be relatively calm on a daily volatility basis when greed reigns, and incredibly chaotic when fear rules the roost.

For speculators interested in playing the QQQs, either as outright long or short sales or leveraged through options, paying close attention to volatility indicators is absolutely crucial for discerning short-term entry and exit points.

Our final two graphs this week showcase two popular volatility indicators that can be extremely useful for short-term QQQ speculators. The first is the VXN implied volatility index of the NASDAQ 100 and the second is the incredibly potent VIX implied volatility of the S&P 100 index. Both the VXN (pronounced "Vixen") and VIX (pronounced "Vicks") are calculated using the same methodology representing the implied volatility of a hypothetical 30-day option that is at the money.

QQQs & VXN

As the orange NASDAQ 100 VXN implied volatility line above indicates, the VXN is a relatively new creation. It was introduced in January 2001 to provide a VIX-like indicator that applied purely to the tech giants of the NASDAQ 100. While the VXN has great potential in the future, its limited history at this point in the game mean it must be interpreted cautiously.

With less than two years of data, how can cubes speculators know what a true VXN extreme is? As is apparent above, there have been three major tops and two major bottoms in the VXN already, but they all turned at very different levels. Because the VXN is so young and it was created in the midst of supercycle-bust chaos, no one really knows yet what "normal" VXN readings should look like.

The VXN, even though it directly applies to the same NASDAQ 100 index underlying the cubes, should be approached very warily because of its lack of track record. With this key caveat in mind, the VXN can still provide some fascinating short-term speculation insights.

Extreme volatility always coincides with rampant general fear. Each of the three major VXN spikes since its birth, marked by the black arrows above, has flagged perfect entry points for long QQQ speculations, or selling QQQ put options and buying QQQ call options. With limited historical data, VXN 75 seems to be a reasonable short-term buy signal.

Low volatility usually coincides with widespread greed and complacency. The VXN has carved out two major interim bottoms thus far in its existence, marked with the white arrows above. Both points have been profitable, but not optimal, moments in time to go short the cubes, or sell QQQ calls and buy QQQ puts. So far, a reasonable general short-term sell signal seems to be around VXN 40.

Interestingly, a superior sell signal can be mined from the VXN data. Note that after each major VXN top that volatility rapidly bleeds off and collapses in subsequent months. Following each spike up, there was a sharp plunge below 60 that is readily apparent in the chart above. Somewhere below 60, each VXN deflation following a QQQ bounce fell to a level where it hit serious technical congestion.

The yellow circles above mark this congestion. Rather than continuing plunging sharply, the VXN abruptly halted and suddenly started traded sideways for weeks at a time. Extremely provocatively, this short-term congestion marked the actual tops of each bear market rally incredibly well, as the yellow arrows indicate. It would be much more challenging to spot this congestion in real-time than in a historical chart of course, but it occurred near the VXN 49-54 level in the last two bear rally tops.

While we are constantly continuing to refine our internal Zeal trading models for our own QQQ speculations, a strategic VXN trading methodology based on recent history would be as follows…

"When the NASDAQ and cubes plunge and the VXN rockets up to the 70-80 range, go long QQQs or buy QQQ calls and sell QQQ puts. Then, with shorts closed and longs intact, patiently wait for the VXN to plunge below 60 relatively rapidly. After the VXN bounces under 60, near the low 50s range, wait a week or two to watch for the telltale sideways congestion witnessed above. When the congestion in the low 50s actually occurs, the time to go short has arrived. Sell your QQQ longs and short the QQQs. Also, if you are an options speculator, sell your QQQ calls and back up the dump truck to load up on QQQ puts."

While just using a NASDAQ or cube chart alone makes it difficult to discern future trends, adding in some implied volatility data as an indicator drastically improves the probability of making a successful trade. If you remember that high short-term fear, the perfect time to buy, manifests itself in extreme volatility, you are already way ahead in the game.

While the NASDAQ-100-based VXN seems to be the logical implied volatility index to use for trading the NASDAQ-100-based cubes, this may not necessarily be the case in reality. Provocatively, the S&P-100-based VIX may provide even superior buy and sell signals for the QQQs than the VXN! Our final graph is built on the same methodology, but with the VIX superimposed over the cubes this time.

QQQs and VIX S&P 100

The VXN above had at least three major limitations. First, the VXN has a very limited history so general VXN topping and bottoming levels are not yet known. Second, because the NASDAQ 100 is so incredibly volatile the VXN tops tend to be muddy and prolonged, not precise in terms of a single trading day or two. Finally, the VXN congestion marking cube bear rally tops occurred at significantly different levels, frustrating efforts to discern it developing in real-time.

The venerable VIX, the ultimate implied volatility indicator for the US equity markets, suffers none of these limitations.

As I discussed five weeks ago in "VIX Bounces S&P 500," the VIX has a distinguished history as a phenomenally-accurate short-term sentiment indicator and absolute high and low VIX levels are well known. Even though the VIX applies to elite S&P 100 stocks, which are dominated by non-technology flagship US corporations, it is still extremely useful for trading the cubes.

While there are only about seven massive NASDAQ 100 companies also listed in the S&P 100, the NASDAQ short-term action is heavily dependent on general US equity market greed and fear. In the last two major bear rallies in the US markets, the S&P 100, S&P 500 (which contains the S&P 100), Dow 30, and the NASDAQ 100 have moved like Siamese twins joined at the hip. General market greed and fear dramatically affect the NASDAQ and the cubes.

Since the VIX effectively measures general US market greed and fear, it may be even more useful than the still immature VXN as a QQQ speculation timing tool. Note in the graph above how VIX spikes are generally sharp and of short duration. Unlike the VXN, the VIX doesn't take weeks to make an interim top, a very useful attribute for short-term speculators. Each interim VIX top precisely flagged a QQQ interim bottom, marked with the black arrows above. This general QQQ buy signal is in the high 40s in VIX terms.

Just as the VIX irons out the muddy VXN tops, it has a constant bottoming level over time, roughly 20. If the VIX plunges to 20, extreme complacency and greed abound and it is the time to sell the cubes. The white arrows above mark profitable QQQ sell signals generated by interim VIX lows.

Interestingly, the theory of VXN congestion as a sell signal also works with the VIX, but it is much clearer! The yellow circles above mark VIX congestion levels. On the VIX, after a steep fall from an interim top, congestion developing around 25 has coincided virtually perfectly with short-term QQQ tops. Unlike the VXN, in the two recent bear rallies the VIX congestion occurred really close to the same 25 level, a big added bonus for real-time analysis.

A strategic short-term QQQ speculation model based on the VIX would work as follows…

"When the NASDAQ and cubes plunge and the VIX explodes to the high 40s, go long QQQs or buy QQQ calls and sell QQQ puts. Then, with shorts closed and longs intact, patiently wait for the VIX to decay below 30 relatively rapidly. After the VIX bounces under 30, near the 25 range, wait a week or two to watch for the telltale sideways congestion seen above. When this technical congestion in the mid 20s occurs, the time to go short has arrived. Sell your QQQ longs and short the cubes. Also, if you are an options speculator, liquidate your QQQ calls and load up on QQQ puts."

These basic volatility rules for trading the QQQs are definitely strategic in nature. They can be further refined on the tactical level without a doubt, something we are working on at Zeal. Other indicators can be added to the primary volatility indicators to offer even more solid and clear buy and sell signals for speculators playing the NASDAQ in either direction, long or short.

If you have risk capital separate from your core long-term investments that you are interested in speculating in the QQQs with, but you don't have the time to constantly watch and evaluate the markets day in and day out, we do publish an acclaimed monthly newsletter called Zeal Intelligence that outlines our own real-world real-time options trades.

All of our ongoing research and trading model refinements continue to flow into our current and future trades, specifically recommended and continuously tracked in our newsletter from our initial buy signal to final sell signal. We can do the time-intensive homework for you, offer our best detailed trading ideas, and then you can choose if they make sense and match your own risk tolerance for a possible mirrored trade of your own.

As an added bonus, if you honor us with a new subscription today, we will promptly e-mail you a complimentary copy of the current September issue of Zeal Intelligence, which outlines what we call "The Big Trade," a major opportunity to multiply capital in QQQ options coming down the pike that we expect to take full advantage of later this autumn when it matures.

My essay this week is a necessary step along the path of refining our short-term speculation models to attempt to grant our clients and ourselves an optimal shot at The Big Trade approaching.

Thank you for spending your valuable time reading this initial foray into using implied stock index volatility indicators as primary tools for trading the cubes. I truly hope your own personal journey as a speculator is blessed with both fantastic intellectual dividends and legendary profits!


 

Adam Hamilton

Author: Adam Hamilton

Adam Hamilton, CPA
Zeal LLC.com

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Mr. Hamilton, a private investor and contrarian analyst, publishes Zeal Intelligence, an in-depth monthly strategic and tactical analysis of markets, geopolitics, economics, finance, and investing delivered from an explicitly pro-free market and laissez faire perspective. Please visit www.ZealLLC.com for more information, www.zealllc.com/samples.htm for a free sample, and www.zealllc.com/subscribe.htm to subscribe.

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