Trading Volatility Ratios

By: Adam Hamilton | Fri, Oct 4, 2002
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Just as in life, strategic perspective is priceless when studying the markets.

There are rock-solid, fundamental realities underlying both life and the markets. As each of us proceed through life and investing, we strive to understand and grasp the true fundamental realities below the surface. The more fully we comprehend the forces behind the scenes really driving life and markets, the better we can adjust our own paths to increase the probability of achieving our dreams.

This idea is certainly not new. Celebrated ancient Greek philosopher Plato described his Theory of Forms four centuries before Jesus Christ was born. Plato, influenced by his mentor Socrates, was convinced that there were fundamental realties under the surface of life that we should diligently attempt to understand. He was convinced that knowledge was attainable and that knowledge was certain and infallible.

Plato's Theory of Forms stated that we should strive for knowledge on what is absolutely true and real, underlying realities, rather than merely what we perceive. The Theory of Forms ties in closely with perspective and is useful as a valuable paradigm through which to view today's chaotic financial markets.

There are indeed immensely powerful forces lurking under the surface that actually drive equity markets, both over the long-term and the short-term. History has unambiguously shown that the prime mover over the long-term is valuation. Individual stocks and entire market indices inevitably ultimately regress to some reasonable mean multiple of the earnings that they are able to spin off for their shareholders.

Over the short-term, the prime mover of the equity markets is general market psychology. The short-term history of the markets is dominated by the titanic and ever-warring emotions of greed and fear, welling up deep within all human hearts. Somewhat paradoxically, just as contrarian investment theory predicts, markets tend to fall on extreme greed and rally on extreme fear with stunning consistency.

Contrarian investment and speculation theory, while very simple, can be difficult to apply in real-time to real-world situations. On the short-term speculation front, how does one know when greed and fear have reached tradable extremes? When is the optimal time to be long or short for short-term speculative profits?

One approach for today's speculators to apply Plato's theories to their own personal intellectual speculation journeys is to view the markets from alternative perspectives. Just as you are not able to see an entire room at once if you are standing in the middle of it and only looking in one direction, it is difficult to get a feel for the sentiment state of the markets as a whole if you are fixated on only the market indices themselves.

By merely looking around, analyzing and digesting the whole room, you gain a much broader strategic understanding of the room. The same theory applies to the markets. If all a speculator looks at are the daily closes of the Big Three US equity indices, it is difficult to gain a proper strategic perspective on what is really transpiring. Plato's Forms, underlying realities, remain obscure if one's perspective is too narrow and myopic.

Eight weeks ago I wrote an essay called "VIX Bounces S&P 500" that discussed using the S&P 100 Implied Volatility Index (VIX) as a technical tool to gain a broader perspective on what was actually transpiring underneath the market surface in terms of actual general greed and fear levels.

At the time the VIX suggested that fear was extreme so the high-probability speculation was to bet on the long side. So far it has been right. While the last eight weeks have certainly been volatile and chaotic, the July 23rd S&P 500 closing low of 797 has thus far held solid.

One day after that essay was published, a speculator friend of mine wrote and offered me some valuable perspective-enhancing insights. My friend, Dan Basch, has been working on explorations into various ratio analyses as tools to enhance his own short-term speculation success. I was very excited when he shared some of his findings with me. Now having watched one of his many discoveries unfold over two months, I couldn't resist sharing it with you.

In the financial markets, ratio analysis involves taking one variable and dividing it by another. The resulting quotient is then graphed. Standard technical analysis can then be applied to the graphed ratio, yielding valuable market intelligence often unavailable elsewhere. Good well-thought-out ratios offer new insights and an entirely different perspective on true underlying fundamental realities, enhancing our ability as speculators to understand the Platonic Forms relentlessly driving markets just below the surface.

Mr. Basch had been watching the S&P 500 and the VIX to time his own long and short trades, like many other contrarian speculators. As he attempted to broaden his perspective and understanding, he decided to divide the S&P 500 (SPX) by the VIX to create a shiny new ratio to analyze. The results are graphed below and are quite interesting.

Since Basch's ratio is heavily dependent on the VIX, you will get much more out of this essay if you understand the VIX. If you are not familiar with this amazing technical sentiment timing tool, you may wish to skim the following essays. "VIX Bounces S&P 500", "Volatility Trading the QQQs", and "Handicapping Market Crashes" all provide foundational information that led me to write this essay. If you were listening to Professor Plato in his Academy in Athens almost twenty-four centuries ago, the first European university in history, he would say these earlier VIX essays are necessary prerequisites for digesting the full speculative implications of the SPX/VIX ratio.

Here's a Zeal version of the first graph Mr. Basch showed me. His ratio is graphed on the right axis and the S&P 500 itself commands the left axis.

Trading Volatility Ratios

Basch's ratio is very intriguing as it has somehow managed to carve out a gorgeous trend channel that is nearly technically perfect. Since 1999, before both the NASDAQ bubble popped and the S&P 500 started its flat-spin into the depths of despair, the SPX/VIX ratio has formed a rock-solid downtrend pipe. While its upper resistance line isn't quite as well defined, its lower support line is simply awe-inspiring.

The SPX/VIX ratio has bounced off its heavy lower support line not twice, not three times, but an incredible five times in a row now! Often trendlines in technical analysis are based off only two or three intersections with market price action. Each of the five bounces off the support, marked with the yellow arrowheads pointing up above, together create an immensely powerful technical precedent.

It is just not that often that a trendline is this well defined! The anomaly is even more impressive in the context of pure ratio analysis. Since ratios tend to dilute the two parent variables that give birth to the actual ratio itself, it can be challenging to technically analyze the ratio itself since its trend often isn't as clear. Like a baby, a ratio has traits from both its genetic father and mother, so its behavior on the charts is often fuzzier than that of its parent variables.

The SPX/VIX ratio however, has been amazingly consistent in terms of bouncing off its lower support line with great regularity and stability. Even more provocatively, each time this ratio bounce has occurred, it has marked a perfect opportunity to go long for a short-term speculation! If you analyze the chart above, you will notice that large long side profits for S&P 500 index speculators have been achievable after each prior SPX/VIX ratio bounce.

While merely looking at the S&P 500 alone would not have allowed speculators to perceive all these outstanding long trading opportunities, the SPX/VIX ratio expands one's perspective enough to gain a superior understanding of the true state of the markets underneath their turbulent surfaces.

Another fascinating development that Mr. Basch pointed out to me was the incredible similarities between the SPX/VIX behavior in the last couple months with its behavior in 1998. Both episodes are marked above with the dark gray circles. While not apparent in the broad time scale graphed, the comparisons are even more compelling when zoomed in to focus on both circled regions.

Just like today, late 1998, when the Russians defaulted on their sovereign debt and elite hedge fund Long-Term Capital Management imploded in a spectacular fireball, was a time marked with horrendous general fear in the markets. An incredibly steep S&P 500 plunge occurred to drive fear and the VIX up to short-term capitulation extremes, just as in this past summer in 2002.

Yet, in the very midst of the darkest hour when all seemed lost, the Panic of 1998 marked the perfect time to go long for a short-term speculation. The SPX/VIX ratio fell below 20 twice, just like today, and then it was off to the races. While the S&P 500 was indeed still in a magnificent bull market in 1998, compared to a horrific supercycle bear today, the comparison of the two short-term panics is probably more valid than it appears at first glance.

Yes, valuation certainly drives markets over the long-term, but all that matters in the short-term is sentiment, general greed and fear. Somewhat paradoxically, bear market rallies are among the most powerful and sharp of all rallies over all of market history. Since fear is the emotion that dominates secular bear markets, greed really tends to flare-up fast once it gets a chance to assert itself again, even if only for 6-8 weeks, the typical bear rally lifespan.

Even though the autumn 1998 panic marked an interruption in a great bull and the summer of 2002 panic marked the continuation of a great bear, both situations represented enormous extremes of short-term fear. Both are perfect environments from which to launch spectacular relief rallies. Just as the previous two magnificent S&P 500 rallies in this ongoing supercycle bust were mammoth, this potential third one has the psychological foundation in place for being truly extraordinary as well.

The SPX/VIX ratio has thrown off a massive buy signal and speculators should consider paying attention.

Our next graph simply zooms in a bit, focusing on the SPX/VIX ratio's performance as a timing tool exclusively in the context of the brutal supercycle bust which followed the S&P 500 bull market apex.

Trading Volatility Ratios

Once again, the buy signals to go long in Basch's ratio since the bust began have been exquisitely perfect, marking exact bounce points for eminently tradable bear market rallies. The SPX/VIX ratio has rebounded off its heavy bottom support line four times since early 2000.

Unfortunately the sell signals to go short are not as clear in the SPX/VIX ratio. The three major tops in the ratio marked above by the inverted yellow arrowheads all occurred at different levels. The tops are not linear with each other and not exactly parallel with the bottom trendline. Nevertheless, whenever the upper resistance line for the ratio shown above was kissed or pierced, it did mark an excellent opportunity to go short for big profits, even if the timing signals weren't optimal.

Just like a baby, a ratio inherits good and bad traits from both of its parents. As I discussed in "Volatility Trading the QQQs", the VIX itself is somewhat ambiguous in marking exact short-term market tops. The VIX is much better at measuring extreme fear, the time to go long, than extreme greed, the time to short. This limitation is not a big problem and doesn't negate the value of this timing tool, but it is just something that all speculators need to be aware of.

Due to the asymmetric nature of greed and fear extremes in brutal Great Bear markets, the VIX and all its progeny like the SPX/VIX ratio provide short-term buy points with laser-like precision, but they do not define short-term tops quite as well.

In the bottom right corner of the graph above, you can see two small solid trendlines. These are provocative and may unlock the mystery of whether a bear rally is indeed heading our way or not. Both the S&P 500 and the SPX/VIX ratio have held modest uptrends since their late July lows. We interpret this development as an initial fledgling sign of strength below the surface indicating that the S&P 500 still "wants" to rally and certainly hasn't given up its ghost yet.

Our final graph this week compares the SPX/VIX ratio with the NASDAQ 100 Trust, the ubiquitous QQQs preferred by speculators around the world. Our time horizon is shrunk once again to only encompass the recent bust events of roughly the last couple years.

QQQs and Volatility Ratios

Yet again, Basch's ratio yielded stellar buy points to go long in the last two major bear market rallies in the NASDAQ 100. The sell signals were not as optimal, but they certainly weren't too bad either. Any speculator who shorted the Cubes on the SPX/VIX ratio tops and covered on the bottoms has done extremely well in this most difficult of market environments.

Notice the two small solid trendlines once again in the lower right corner above. While the SPX/VIX ratio is trending higher, the QQQs, NASDAQ, and NASDAQ 100 are all drifting lower. The July 23rd low of 1229 on the NASDAQ couldn't manage to hold and the embattled index carved a fresh new low of 1172 on September 30th. In QQQ terms these descending lows translate into $22.40 and $20.72, respectively.

This positive divergence between the SPX/VIX ratio and the NASDAQ is very interesting. If the S&P 500 and VIX are right and a massive bear market rally is imminent, the NASDAQ will have to come along for the ride. In recent years the NASDAQ and the much broader and larger S&P 500 have been joined at the hip like Siamese twins. In order for this divergence to close, the NASDAQ would have to rally significantly farther in percentage terms than the S&P 500.

If you speculators believe the bear market rally thesis has merit, you may wish to deploy your capital on the long side accordingly. If the bear rally is to continue and accelerate in S&P 500 terms, the NASDAQ's rally to catch up with its older cousin will be much more violent and powerful.

After two months of pondering this ratio and chatting with Dan Basch, I don't believe there is any reason to expect the SPX/VIX ratio's massive strategic downtrend to end soon. If we can assume that the VIX extreme fear level will remain around 50, as I personally believe, then the ratio's downtrend should hold. At an S&P 500 level of 700 and a VIX of 50, the ratio would bounce at 14. At an S&P 500 level of 500, it would be 10. The downtrend should hold as long as the VIX doesn't wax insane.

Now I am fully aware that many very intelligent speculators out there believe the VIX will rocket above 100. As I explained recently in "Handicapping Market Crashes" however, I don't buy into the VIX 100 theory. I could certainly be proven wrong, but a couple major factors that are apparent in our research lead me to believe we will not see such hyper-VIX extremes in this supercycle bust.

A VIX 100 would almost certainly require a market crash, a single day decline of the S&P 500 of 10%+. In history crashes always happen within about 5-8 weeks after major market tops, not years into a bust commencing from major market lows. In addition, the timid cowards regulating the US markets have shoved in a bunch of feeble anti-free-market schemes to limit big down days.

After the Crash of 1987, the goofy control-freaks running the US stock exchanges decided, in a moment of blinding arrogance, that they were smart enough to second-guess the free markets. So, assuming that investors and speculators can't be trusted to think and trade for themselves, the regulators instituted so-called circuit-breakers. These rules are designed to shut down the equity markets if there is a large daily plunge.

Because these Soviet-Politburo-style central planners running the US stock exchanges will panic like hysterical schoolgirls and shut down the markets if there is even the hint of a big single-day plunge, the odds of another October 1987 event are exceedingly small. If circuit-breakers can really prevent single-day crashes, which remains to be seen, we may never see another VIX 100+ close again.

It is truly sad that investors and speculators, all adults fully responsible for their own actions, are not allowed to buy and sell in panics, often times of tremendous opportunity. Artificially suppressing the normal healthy panic process, which is a crucial blow-off valve to bleed excess euphoria before it leads to a mania, leads to brutal depressions later. The practice reminds me of the dangerous folly of the bureaucrats at the US Forest Service in suppressing every little fire, which are normal healthy occurrences to keep forest brush growth in check, which inevitably leads to monster fires like we witnessed this summer.

As Plato elegantly stated twenty-four centuries ago in his Theory of Forms, there are indeed fundamental truths that underlie the financial markets. As speculators we vastly improve our odds of success if we can broaden our perspective and understanding of the markets by considering more than just index levels.

I am indebted and thankful to my friend Dan Basch for helping me expand my own perceptions and understanding of the underlying realities of the markets by sharing his SPX/VIX ratio work with me. It is a valuable tool in a contrarian speculator's arsenal to help him or her overcome the innate psychological stumbling stone we all have of becoming fixated on daily index closes rather than seeing the big strategic perspective.

If the SPX/VIX ratio proves true to its golden historical track-record, we are in for a spectacular bear market rally that will knock the socks off those not expecting it and yield legendary profits for those who are.


 

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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