membership



VIX Term Structure and Its Influence



Is the VIX Term Structure the Worry some Technicians Believe It Is?

Technical Backdrop Is Leading Many Traders into A Crowded Short Position!



Share

February 27, 2012

Introduction

Stocks racked up a few new multi-year highs last week, although the major market indexes finished with relatively minor gains. Traders took heart in a generally decent slate of domestic economic data, but steadily rising oil prices sparked some anxiety about the fragile state of the recovery. Plus, the Dow Jones Industrial Average (DJIA) made its first journey north of 13,000 in years -- which prompted a lively round of "too far, too fast?" banter, particularly with the euro zone still teetering on the edge of a recession. However, it makes you wonder whether technicians have grown too gloomy, too fast. With traders touting a laundry list of potentially bearish indicators, it is important to check the numbers to see how accurate these sell signals have been in the past.

"Volume in a leveraged exchange-traded note that tracks futures contracts in the market's favored anxiety index, the VIX, soared in the last two weeks, as investors bet the recent calm in markets would not last. It forced Credit Suisse, which offers the VelocityShares Daily 2x VIX Short-Term exchange-traded note, to stop issuing shares out of concerns that demand for the security would start to have an undue influence on the price of VIX futures, rather than tracking that market."
- Reuters, February 23, 2012

"Hedge funds have stepped back into the market after a cautious year end, but they're advancing cautiously... Last year, for example, hedge funds were taking a much bigger bet on stocks rising. This time last year their net positioning -- longs minus shorts -- was as high as 51% at Credit Suisse. Today it's 36%, up just slightly from 32% at the start of the year. Cash levels, meanwhile, are higher at about 22% than they were in early 2011, when they stood at 18%."
- The Wall Street Journal, February 22, 2012

It is always important to use a combination of technical and sentiment tools to gauge the health of the market from a risk and reward perspective. Even though practitioners of technical analysis and many technicians are to be respected, it is a realization that technical analysis is not flawless. Moreover, like any other investor or trader, technicians can sometimes get themselves into crowded trades, leaving them vulnerable to situations in which the market behaves in the exact opposite manner than what their research suggests.

Technical Analysis is a method of evaluating securities by analyzing statistics generated by market activity, such as past prices and volume. Technical analysts do not attempt to measure a security's intrinsic value, but instead use charts and other tools to identify patterns that can suggest future activity.

Technical analysts believe that the historical performance of stocks and markets are indications of future performance.

In monitoring various Twitter feeds and media sentiment, it appears the market's current technical backdrop is leading many traders into a crowded short position, which could resolve itself by stocks charging ahead longer than many expect. For example, during the past week, we have seen pullback warnings driven by the following factors:

1. The Average Directional Index (ADX) of the S&P 500 Index (SPX - 1,365.74) is above 40 and at an extreme, which means the trend is overextended and potentially mature.

2. The percentage of stocks above their 50-day moving average is more than 80%, suggesting the market is overbought.

3. The number of market indicators that are diverging as the SPX is making new highs is growing, suggesting the quality of the rally is decreasing. Many point to the recent weakness in the Dow Jones Industrial Average (DJIA - 12,982.95) and the smaller number of 52-week highs. (Side note: Given the weakness of the market from this time last year through March 4, the number of new 52-week highs could increase again over the next few weeks, as comparisons become easier.)

4. CBOE Market Volatility Index (VIX - 17.31) futures are relatively high as compared to cash VIX, which is being interpreted as bearish among VIX followers.

Average Directional Index – ADX is an indicator used in technical analysis as an objective value for the strength of trend. ADX is non-directional so it will quantify a trend's strength regardless of whether it is up or down. ADX is usually plotted in a chart window along with two lines known as the DMI (Directional Movement Indicators). ADX is derived from the relationship of the DMI lines.

ADX



Analysis of ADX is a method of evaluating trend and can help traders to choose the strongest trends and also how to let profits run when the trend is strong.



022712-VIX



The technical situation described in the four examples above is certainly one that warrants attention. But one has to wonder, have these factors already been baked into the equity market? One could argue they are, as traders trip all over themselves to buy leveraged volatility vehicles, in anticipation of a volatility spike driven by a short-term pullback in the market. There is a feeling that leveraged vehicles are playgrounds for speculators, not necessarily hedgers -- suggesting there is still a healthy degree of skepticism among short-term traders within the context of a strong, short- and intermediate-term trend higher.

Moreover, sometimes an indicator gets more play than what it is worth. For example, the "Term Structure" that is worrying some traders does not have a consistent track record, as measured by the two-month VIX futures trading at a significant premium to cash VIX. Around the middle of last week, two-month VIX futures were trading 38% higher than cash VIX, which is extremely high, and alarming to some traders.

It has been observed that there were 36 instances since 2004, when the two-month VIX futures were 25% higher or more than VIX cash, and found that this "bearish" signal is not all that bearish after evaluating the signals. In a study put forward, more than one signal over any 20-day period could not be accepted. Per the table below, it is to be found that the market has slightly more than coin-flip odds of advancing three, five, and 10 days later. Beyond 10 trading days, the odds of a decline are stacked against the bears.

After the study of each and every signal, it is to be found that this "bear" signal worked nicely from January 2007 through July 2010, but since August 2010, the market has actually advanced eight out of 10 occasions when VIX futures were significantly above cash. It is possible that this signal could revert back to being bearish, like the 2007-2010 time frames! However, at the same time, a point to note is that the current VIX term structure isn't a "slam dunk" bearish signal, according to research.

022712-VIX-2



A well-respected, highly-followed trader on Twitter revealed he is short the market and, in conjunction with this revelation, said that the best trades are sometimes the most difficult. This is so often found to be true, as the best trades are sometimes the most difficult to make. But is the short trade, at present, a "difficult" one?

Short Selling is the selling of a security that the seller does not own, or any sale that is completed by the delivery of a security borrowed by the seller. Short sellers assume that they will be able to buy the stock at a lower amount than the price at which they sold short. Selling short is the opposite of going long. That is, short sellers make money if the stock goes down in price.

This is an advanced trading strategy with many unique risks and pitfalls. Novice investors are advised to avoid short sales.

Through Thursday, the SPX was up 24 days out of 36 in 2012 (67%), the highest percentage of days since 1995, when the SPX began the year up 24 out of its first 36 days. As many traders place speculative bets on higher volatility amid perceived deterioration in the technical backdrop and a market vulnerable to more mean reversion, short-term short exposure could be viewed as an easy trade to make, given the company.

Conclusion

Therefore, it appears that short-term long exposure is a difficult trade, given it doesn't seem to be a very popular one with the trading crowd. Moreover, the potential buying power that the hedge funds still possess, and the prospect for an unwinding of the speculative bets against the market, suggests the payoff for long positions remains acceptable.

Share


”Success is simple. Do what's right, the right way, at the right time.”



Option Tip for your Success!
Options traders are not successful because they win.
Options traders win because they are successful.



membership




Back to Home Page







Search Stock Options
Made Easy



Enjoy Relaxed or Fast-Paced Trading? Choose your Membership Style...

Whether you prefer to take a laid-back approach to your trading,

or to charge ahead in your options trading,

 Stock Options Made Easy Armchair Trader and Cut-to-the-Chase Trader Memberships put everything you need to succeed at your fingertips for just  $39 or $79 per month.





Search Stock Options
Made Easy




newsletter-free


Subscribe to our FREE
newsletter for all the latest options news!


Enter Your Email Address

Enter Your First Name











Follow S_O_M_E on Twitter











Subscribe to our FREE
newsletter for all the latest options news!


Enter Your Email Address

Enter Your First Name











Follow S_O_M_E on Twitter