New Paradigm

I'm going to present my thoughts that may be considered way out there...

Complexity theory took hold in economics in the 90s, especially the theory about increasing marginal value or utility(IMV), which turned conventional wisdom of decreasing marginal value upside down. In short, dominate (info, money, power, influence,etc) and set the standards and one could reap ever greater rewards.

This paradigm shift (IMV) and its ultra competitive underpinnings spread to every thread of the fabric of society at the micro level, which in turn set the unintended norm for the macro level--a vicious cycle not only acceptance of, but reverence for those that reaped the highest rewards without questioning whether or if any real value was created and/or how much of the social fabric was destroyed in the process. Societies' value (hence valuation) systems broke down.  In fact, this outcome is exactly what complexity theory models also predicted.

Since the near catastrophic end-game that was the financial/economic crisis of 2008-09, I believe another paradigm has been gaining traction in both the micro and macro levels--that is the theory of a holographic universe. Basically, everything is connected and everything is part of a greater whole. I'm not just pushing some new age, spiritual nonsense. I see it in every scientific discipline and research, in global economic and political policies, in the corporate world, in entertainment, etc.

I do not know what would be the end results of this new paradigm shift, but I have to believe it would be more positive and constructive then IMV.  I'm talking about 10-20 year bull market here... Yes, my outlook is far-fetched, but why not have a vision?

How does one monetize this vista?

Sell assets that have risen due to fear. That would be gold, long-term bonds, anytime VIX spikes. Buy portfolio of assets that are in the business of strengthening connections (human, corporate), perhaps GOOG(YouTube), FB, IACI(match.com), EBAY, media & content firms, crowd funding, etc.  Avoid firms that have traditionally try to profit from transferring costs to society, just to name a few off the top of my head... 


As a side note...ever wonder why "Gangnam Style", song and music video by PSY, a mid-30s, out-of-shape Korean rapper, shattered the record for the most watched You Tube video (over 1.3 BILLION+ views) and became a global phenomenon?  PSY said it himself.  His music, dance, and video focuses on participation and not exhibition.  They allow people to laugh and connect and be in the moment as the actors themselves.  This is completely different than entertainment from just a few years ago when people felt disconnected and perhaps even empty admiring or being envious of the so called "stars".

Options Market Tip 1-16-13

Quick Summary for 2013

http://www.youtube.com/watch?v=rPjVMUwkk2k

Video Shot 1/3/13

VIX Rising to 20.83 in the Next 2 Weeks?

 

As you can see in the chart of VIX above, the P&F Trend Indicator (from MetaStock) that I use for VIX turned positive once again as of VIX closing price of October 19, 2012.  I look at this indicator because it turns positive so infrequently when it comes to VIX.  Last time P&F Trend Indicator turned positive was on May 4, 2012.  At that time, I wrote a research piece titled "VIX Rising to 24.6 Before May VIX Settlement?" in my blog.  In fact, VIX rose from 19.16 on May 4th to 21.97 the last trading day of VIX May expiration.  VIX continued to rise as high as 25.1 over the subsequent few trading days.

The table below shows the instances when VIX was under 25 and P&F Trend Indicator turned positive over the past 12 years.

Unlike in my May 4th post, I added a calculation of averages excluding what I considered outliers (highlighted in green & yellow) to come up with average or expected Max % Gain & Max % Loss of VIX looking 10 trading days forward.  Based on the average numbers, VIX could be expected to rise as high as 20.83 or fall to as low as 16.04 over the next two weeks.  Furthermore, using these VIX ranges, VXX then could be expected to trade within 40.6 to the upside or 33.4 over the next two weeks.  VXX ranges are calculated (roughly) with assumptions about how it has moved in the past relative to VIX movements.

I understand that trying to calculate "Expected" or "Average" numbers with such few data samples is not quantitatively reliable.  Nevertheless, it is a worthwhile exercise to carry out when formulating a trading strategy based on scenarios of how VIX may be expected to move.  Perhaps, buying the VXX November 35/38 call spread could be a good trade.

Differences in Perception & Reality: Time to Go Long Volatility

Back in late August and early September, and ahead of ECB announcement, S&P500 Index experienced a period consolidation.  As you can see in the first blue oval, the market went sideways, then took off after  Draghi's announcement of Outright Monetary Transactions (OTM) policy.  Over the past two weeks, the market has also undergone a consolidation of sort.

The interesting difference between these two periods of consolidation is VIX (shown in plum) movements and my Fair Volatility Estimate or FVE Indicator (shown in blue).  As you can see indicated by the red arrow, VIX steadily rose ahead of the ECB announcement to 18 level, while FVE remained low and in a declining trend.  After the ECB announcement, VIX plunged.

Recently, however, FVE has been steadily rising, yet VIX has remained mostly below FVE Indicator's values during this consolidation and also below its values during the previous consolidation.

The reality is that the current ongoing consolidation of the S&P500 Index is showing greater volatility, yet market volatility perception as measured by VIX is not quite reflecting this.  I believe presents a good expected payoff scenario in favor of going long volatility.

VIX Back Month Futures At Record Premiums!

VIX back month future prices seem really high to me.  March 2013 VIX futures are trading at 27.30, April 2013 VIX futures are 27.85, and May 2013 VIX futures are 28.20!  Historically, the median VIX level has been 19.8.  Furthermore, I calculated that VIX has been above 40 just 3.6% of the times since 1994, but 29% of the times it has been below 16.  With these probabilities, I get 8 to 1 advantage for me to sell back month VIX futures.  I thought this has to be an anomaly!

So I plotted a graph showing the premiums of the first seven, VIX monthly futures prices over spot VIX.  As you can see in Yellow, the rolling seventh month VIX futures prices have indeed been trading at record premiums over spot VIX.  On August 17, when spot VIX hit a five-year low of 13.45, the VIX March futures prices were trading at 93.7% premium.  Since then, VIX has climbed to 17.74, reducing the premium March 2013 VIX futures trade over spot VIX to 53.9%.  However, this premium is still very high based on historical premiums

Something does not make sense, unless...

VIX futures term-structure and the gaping spread between the seventh month VIX futures prices and the second month VIX futures prices are warning us of an impending correction.  In looking at the graph below, the peaks in the spread between VIX seventh month future price vs the VIX second month futures price has preceded 1 to 2 weeks prior to the peaks of SPY prices.  The graph below looks pretty convincing, especially when looking at how closely SPY prices have moved with the rise and fall of the price spread of VIX futures.  Is the recent peak on August 17, 2012 signaling an equity market top with prices expected to start falling any day now?!

 

I am not so convinced of what VIX futures term-structure is signaling...

The graph below shows that prior to SPY price corrections, the ratio of VIX to a measure of realized volatility has in recent years always been on the low side.  The blue lines in the chart below show corresponding values of the ratio of VIX over Realized Volatility right before SPY prices began falling and subsequently underwent either a minor or major correction.  Currently, however, this ratio remains at very high levels.  In other words, realized volatility has been very low recently.  More importantly, realized volatility has yet to show a rising trend.  Until I see realized volatility start to jump in SPY prices, I would remain bullish on the equity markets.

 

I can understand that with SPY prices at new recent highs and with tremendous expectation built in to the equity market for imminent announcement of credible European government and central bank policies, investors would want to hedge their portfolios with VIX futures.  However, the discrepancies between implied volatility and realized volatility to that of VIX futures prices seem way out of line.  Something has to give.  Perhaps buying the 2nd month VIX futures and selling the seventh month VIX futures could be a good bet if the spread between the two is expected to decrease.

Don't Be Puzzled By A Low VIX.

On August 17, 2012, the closing value of VIX was 13.45, a level not seen since June 19, 2007 when the closing value of VIX was 12.85.  The recent lows in VIX has many naysayers talking.  Never mind the fact that SPY prices have hit new highs since May 2008.  "Such a low VIX level shows investor complacency and has been a reliable signal of market tops", claims the talking heads that are equally in disbelief that the equity market keeps going up and up.

I must admit, with all the problems unresolved in Europe, concerns over Chinese economic slowdown, and possible falling off of the fiscal cliff in the U.S., it is easy to sympathize with their arguments that this equity market has been manipulated upwards by central banks and that it is set for a free fall.

I would like to take a different perspective.  Recent earnings announcement from Cisco got me thinking.
1) that the global economy is not as weak as once feared
2) U.S. multinational companies are still enjoying the benefits of global markets reach and growth
3) S&P500 Index is more and more comprised of these multinational, global companies.

So I took IMF's global GDP growth figures and projections and plotted the long-term, monthly VIX inverse levels on top of it.  What the graph below shows is that inverse of VIX follows the annual global GDP growth rates very closely.  Perhaps this is the reason why the equity markets have continued their bull-run and VIX levels have declined to their lowest levels in years.  If the GDP projections end up close to reality, VIX could easily move within 10-20 range as it did from 2003-2006.

Perhaps, VIX falling to 13.45 level recently should be taken as a signal of an equilibrium shift in VIX levels happening before our eyes.  As you can see from the graph below, VIX has in the past moved from low volatility equilibrium to high volatility equilibrium and back and forth.  Should IMF projections for 2013 GDP growth be right in its direction, there should not be a reason to discredit the possibility that VIX has shifted to lower equilibrium levels.

If this is the case, then I must consider utilizing the Blue/Cyan median VIX levels in my models from hereon to calculate expected VIX levels, rather than using the long-term median VIX levels in Black/Grey.  I have not accepted this 100%, but I am considering making this adjustment.

One thing for certain is that VIX futures prices and VIX futures term-structure are still showing a steep contango.  One of the best bets to make throughout the past 11 months was to short front-month VIX futures as the steep premium of VIX futures prices moved to zero at expiration settlement.  I believe that shorting VIX futures would still be a good bet going forward, especially in consideration of the possibility that an equilibrium shift to low levels is now taking place.  I will continuously be looking for opportunities to short VIX futures delta by shorting VIX futures, using VIX and VXX options, shorting VXX, going long XIV, shorting VXZ, or going long ZIV as long as the contango remains steep.