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MONDAY a.m.
April 21, 2003
Defending the VIX
by David Nichols
Lately I've been a little more of a lightning rod for feedback than usual, which always happens at important market turning points. Again I'm seeing the same questions about whether this time the VIX is going to work.
Only time is going to hold the answer. For my part, I'm certain we are still mired in a nasty secular bear market -- and may be for another decade or more -- and I think it's a good plan to "sell hope and buy despair" until it doesn't work anymore.
So before you join the chorus of those writing off the VIX as yesterday's bear market darling -- which, by the way, has occurred at every bear market top -- you should at least give a nod that there's a chance the VIX could keep working as it has for another 10 years or so.
It's also worth noting that the way we look at the VIX also works in a bull market. In a bull phase, the market still oscillates between advance phases and decline phases, as measured by sentiment. We can use the VIX in the same way. The trick is the parameters are different, and in a bull market you want to keep your big-picture bias to the long side.
But it's my feeling that the VIX will always work as a market timing tool, no matter how many people look at it. First of all, knowing about it and really using it are two different things. It's not as easy as it looks. It's very difficult to trust the VIX in real-time -- as we're all going to find out yet again. Plus the VIX is based on actual supply and demand in the options market, and supply and demand doesn't lie. It is what it is.
But there are much more interesting and complicated reasons why the VIX works, and will continue to work. It's because it's one of the only market traits that is anti-persistent . This is a rare and valuable characteristic to find in the markets, and is worthy of very detailed study.
Back in August 2002 I wrote a briefing about this anti-persistence, which I'm going to reprise here, as many may not have seen it. This little essay spells out why the VIX is the single most important tool for market timing.
As far as the current action, the policy to wait until the fear shows up is serving us well. Under the current conditions, the market still has the ability to grind higher. Remarkably, our sentiment tank is rapidly draining towards empty, and is now only 12% full. (See dashboard below for more details.) The warning light is already on. The sentiment tank needs a re-fill. This is a very, very dangerous spot for the markets.
But we'll continue to wait for a catalyst to trigger that all-important spark of fear among market participants. Until we see direct evidence of real emotional selling pressure, the market can continue to grind away at resistance levels, sucking in every last dollar that's ready to make a bullish bet, or forcing every last bear to cover short positions.
H.E. Hurst, Persistence, and the VIX
(August 13th, 2002 Morning Briefing)
Most of you have realized by now that the Volatility Index (VIX) is my favorite technical indicator. The VIX is so valuable because it is a direct, real-time measurement of the implied volatility in options pricing. It reflects the real-time sentiment of traders, and shows in detail how people are actually spending their money in the options market.
But to really understand why the VIX is so darn valuable, you have to know a little bit about an obscure British hydrologist named Harold Edward Hurst.
H.E. Hurst became intrigued with the Nile River while a civil servant in Cairo in 1908. Actually, it was more like obsessed: His mathematically curious mind led him to examine 800 years of flood data on the Nile River basin. He was surprised when he noticed in the data that good flood years were generally followed by good flood years, and bad years begat more bad years.
Hurst knew that he was onto something, so he dug in even deeper. In an effort to quantify and predict these flood characteristics for reservoir planning, Hurst developed his "Hurst exponent", which is an elegant and precise method of measuring whether or not there is persistence in a data series. Hurst noticed that most natural phenomenon that most thought were random -- like rainfall, flooding, sunspots, etc -- were actually persistent, and exhibited a "memory effect." In other words, what just happened had a tendency to influence what was about to happen.
We all know from first-hand experience that financial markets are persistent in just this way. The old truism that "the trend is your friend" turns out to be exactly right. Studies on S&P 500 historical data show it to have a Hurst Exponent of .78, which means it is highly persistent in its trends, and not random at all, as some misguided academics would argue. A Hurst Exponent of .50 equates to random price movement.
Interestingly, studies have also shown that this memory effect in the S&P 500 lasts about 48 months, after which this effect completely diminishes. This fits in well with the regular 4 year cycle in the markets.
All markets show varying degrees of persistence. Currency markets are the most persistent. Futures traders know this very well, as currency markets often show amazing trendiness. This persistence of price is the main reason it's generally not a good idea to fight the trend, but much better to just "go with the flow."
Interestingly, the rarest thing in financial markets is a trait that is anti-persistent -- that is, it tends to do exactly the opposite of whatever it just did. It doesn't trend. It oscillates. Volatility is anti-persistent, and this is why it's so useful.
Volatility has a strong tendency to revert to the mean. A period of high volatility is followed by a period of low volatility. A period of low volatility is followed by a period of high volatility.
Here's how this looks on the chart of the S&P 500:
The VIX also moves back and forth, anti-persistently:
This anti-persistence gives us a nice oscillatory path to anticipate for the VIX. A technical indicator is only valuable if you have a pretty good idea of what it is going to do in the future. With the VIX, we always know that its tendency will be to revert back to the mean, and do the opposite of what it just did.
This also works so well because high volatility is very much associated with price bottoms, and low volatility with price tops. This is not a hard-and-fast rule, mind you, but it's definitely an idea that will make you money time and time again.
So when we examine the motion of the VIX in real-time, we look for these anti-persistent, mean-reverting swings. It's a constant back-and-forth cycle on the VIX -- just as the market is constantly in a process of oscillating between advance phases and decline phases. Watching these oscillations lets us know exactly where we are with the market, in whatever time frame we want to examine.
Since price is persistent and trendy, then often a "decline phase" as signaled by the VIX won't actually see prices decline, or an "advance phase" won't see prices go up. During the bear market, there were often short-term advance phases where the market actually declined in price. That's a sign of a very persistent downtrend, and a very weak market, by the way. Such divergences in price and sentiment are some of the most valuable clues that we can observe.
There's obviously more to it than just this, but in a sense it's not necessarily beneficial to stray too far away from this picture of the markets I just outlined. Sentiment oscillates back and forth between fear and greed, and by closely studying the VIX and price we have a way to catalog and examine this.
And hopefully profit from it!
Sentiment Dashboard
by Adam Oliensis
SENTIMENT TANK: The tank drained 5 points to 12% full of negative sentiment on Friday. The tank has dropped from about 50% on 3/31/03 to 12% as of 4/17. Meanwhile the SPX has gained just over 5%. That's only about 1% price gain for each 7.5% of negative sentiment burned. At that rate we have less than 2% price appreciation to go. While things don't ordinarily work out quite that neatly in reality and it is POSSIBLE for the tank to go to 0% and stay there, that would imply that we are moving into a market with altogether new sorts of properties, one that would be a distinct departure from the market of the past 3 years. From our current vantage it looks much more likely that we're forming some sort of intermediate top.
We'd become more bullish if the tank would take on lots of fuel during a mild price dip.
SHORT-TERM: The hourly gauge flirted with turning down late last week but closed the week in a very mature advance phase.
MID-TERM: The mid-term gauge gained 3 points on Friday to 98% in its advance phase.. This advance phase is reaching toward its terminus. The Confidence Diffusion index (CDI) is at a middling level of 3. The tank's bearish divergence from price keeps our confidence lower than it would be otherwise. As does the low absolute level of the VIX (under 25).
LONG-TERM: The weekly gauge popped 16 points to 70% last week. Our weekly CDI is at 4. The weekly advance phase looks to be solidly underway. It would be par for the course if the mid-term gauge were to undergo an interim decline phase now that it has solidly dragged the weekly gauge into an advance phase.
Se não receio o erro é porque estou sempre pronto a corrigi-lo
There's no bull side and no bear side. JUST THE RIGHT SIDE!
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