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Dog-Day Summer: Scratch The VIX Fleas

Summary On a go-nowhere market day in mid-summer, the institutional investment management “B” teams are in charge under the remote watchful eyes of the vacationing “A” managers. An SA contributor perfectly times a clearly-written explanation of how several VIX-index derivatives do their thing, presenting numerous onlookers intellectual advancement opportunities for money-making insights. Eager observer participation comments encourage a demonstration of crowd-source strength that makes Seeking Alpha a stand-apart site of internet information exchange. Adding to the present contributions, this article provides a behavioral analysis dimension to the discussion, digging deeper into what makes the securities markets game challenging. Market-makers [MMs] use the VIX in ways that provide expanding opportunities for individual investors to gain market outlook perspective. New ones are about to arrive. The Market-makers’ Game Playbook It’s a game because everyone’s outcomes depend on someone else’s actions. Both initially (opening a position) and ultimately (closing the position) require an other side of the trade. It’s a great game, because we can’t be sure what that guy (or guys, and gals) are going to do next. Lots of game strategies can work, and are continually in play. Plenty of action in a trillion-dollar-a day market. But which way is the emphasis heading, enthusiasm or caution, greed or fear? Who knows what evil lurks in the hearts of men? Heh-heh-heh. The VIX knows! And because its calculation is rigidly defined and regularly measured, it is constantly watched. It is an objective appraisal of the most subjective element in the game. Starting 7/23/2015 additional coloration will enrich the speculative confusion. The VIX index is calculated from premiums paid for options on near expiration contracts on the S&P 500 index. Caution! Objects in this mirror are closer than they may appear! Those contracts have expirations with monthly granulations. But on 7/23 futures and options start trading in the VIX with weekly expirations. Why? Market professionals are consummate hedgers, hate risk, unless they get paid (extravagantly?) for bearing it. In the process, time has profound value. Hedging markets for equity securities have all-along had an inverted “yield curve.” Back in the old days of economically honest (non-governmental interference) markets for “risk-free” U.S. Government Treasury Debt securities, short duration obligations – bills – would carry small interest costs. Obligations with longer periods of time before the investor has his principal returned, paid larger yields. Logically, the more time before you got your bait back, the more likely something might go wrong. You need to be paid for that risk. It still works that way, but now the curve between 30 days and 30 years is a lot flatter. Not so in street equity financing. Market capital typically has huge return potentials in the immediate time frame. Every last scrap of capital that can be declared and committed earns something at the measurement hour. Street capital is required by means of “haircuts” to be reserved, unproductive, against potential disaster. The crisis of 2008 made the dangers clear. The cost of raising capital to meet regulatory requirements makes immediate capital availability dear, while long-term (days, weeks) capital is far less demanding, cheaper. If a hedger can arb a position with a one-week security instead of a one-month one, it is like found money. So the game rules are being eased, and weekly VIX expirations are coming. All very rational. But it may also be very informative. Or not; we really can’t be sure. Here is the CBOE’s official statement : VIX Weeklys futures began trading at CBOE Futures Exchange (CFE®) on July 23. VIX Weeklys options are expected to begin trading at Chicago Board Options Exchange, Incorporated (CBOE®) shortly thereafter. What do we know now? The VIX index tells the amount of uncertainty present in the prices of options on the S&P 500 Index (SPX). But it cannot distinguish any directional balance between upside and downside in that uncertainty. In fact, changes in the size of the VIX calculation are a resultant of the behavior of investors, not in themselves a forecaster of behavior. Observers have learned that fearful investor actions cause the VIX to rise, and reflections of comfort and reassurance cause it to diminish. When the VIX is high, it is because investor concerns are already high, usually because stock prices have already dropped some. How much worse it might get is hard to tell, since that bound has been erratic. The comfort side of the proposition is much more clearly defined and more frequently visited at 10 to 12. The introduction of options trading in the VIX Index in February of 2006 gave us the ability to apply to the VIX the insight we have in appraising the investor expectations we have for individual stocks and ETFs. The balance of expectations between upside and downside prospects measured by the Range Index became available to the VIX in 2006. We achieved the ability to forecast the directional inclination of what many observers took to be a forecasting device itself. A forecast of the forecast. But it hasn’t been the magic many have hoped for. Here are recent measures of the price range implications for the VIX, daily for 6 months in Figure 1, and once a week samples of that weekly for the past 2 years in Figure 2. Figure 1 (used with permission) Figure 2 (used with permission) It should be apparent that market professionals have a good sense of when investor confidence is high, because then the VIX is low in its expectations range, seen as green in these pictures. Prior experience since 2006 has been similar to these at the low extreme, and only more aggravated, but still irregular, on the high side. The small thumbnail picture at the bottom of Figure 2 shows what the distribution of VIX RIs has been daily over the past 5 years. The shape of its distribution is heavily skewed to the low end of a normal stock’s typical, fairly symmetrical, bell-shaped curve experience. The scarcity of VIX pricings at or above a mid-RI level (where prospects for market decline are as great as for price increase) should be a reassurance that markets still remember having grabbed the hot end of the match in 2008. But the RI distribution before the past 5 years is just as healthy, because there had been bad market experiences previously, and they too were remembered. In all, the evidences of U.S. equity market functionality over the past few decades are quite reassuring, largely because of its demonstrated recovery capacity. At the heart of that capacity is the market-making community’s self-protective instincts and its arbitrage skills in making risk-reward tradeoffs. Risks usually can not be eliminated, but can be transferred to those with the capacity to bear them, if appropriate price tags are attached. This is the heart of the insurance concept. This only breaks down when widespread fraud permeates the system, as was the case with mortgage-backed securities in 2007-2008. That was on a scale large enough to threaten the entire financial system and damaged important parts of it badly. Forecasting the “forecaster” We have the ability to infer when the VIX is at comfortable levels and to know when it has jumped to altitudes unlikely to be sustained. Can we make money with that knowledge? Let’s take a closer look at the VIX’s own price behavior following the presence of various levels of Range Indexes. Figure 3 shows what that has been over the past 4-5 years: Figure 3 (click to enlarge) The VIX Range Indexes currently indicated in Figures 1 and 2 are right at the bottom of a normal expectations range, with all upside “reward” and no downside “risk.” In Figure 3 that is indicated by the magenta color of the count of past RIs with similar RWD:RSK balances of 100:1. The blue 1 : 1 row is an average of all 1130 observations from 1/19/11 to 7/22/2015, cumulated from progressive rows above and below. But keep in mind that with the VIX, price direction of the market is inverted. Vix goes up whem markets go down. Given that, in terms of market outlook, there may be room for some concern. And that concern is what causes technical analysts to claim “bull markets climb a wall of worry.” We’re not ever in the technician camp, but let’s take a look at what is being implied by the numbers. If the VIX is to behave (exactly) as it has in the average of 208 prior experiences, that index might rise by +4% during the next week. A quick reference back to Figure 1, tells that the behavioral analysis implies that the Index could rise in the foreseeable future (weeks to months) from its present $12.12 to 16.74 or some 38+%. So maybe 1/10th of that +4.62 rise or $0.46 might happen right away. After 7-8 weeks it might be double that, +8%. Are we scared yet? Seems like sort of noise-level variations. Odds of it happening in the past have been little better than a coin-flip, about 5 out of 8. If the VIX went from $12.12 to $13 and its expectations stood still, then the Range Index would be 20-25 with not much change in prospect from where we are now. And maybe 7-8 weeks have passed. For a MM, 7-8 weeks are an eternity. They don’t husband their time, they pimp it. Conclusion No, to make what we know more valuable, we need a much more aggressive and productive strategy than simple asset-class allocation guesses. From what several commenters and some SA contributors have suggested there are effective strategies in place and being acted upon. Discussions to date have been light on the use of the ProShares Short VIX Short-term Futures ETF (NYSEARCA: SVXY ). It has a significant place in this ongoing discussion but has a tale of its own to tell and should be the subject of a separate article, to follow shortly. The enrichment of weekly data availability may make the discussion even more interesting. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Why You Should Be Playing Defense In This Market

Summary Why you should always be thinking about protecting your assets. Why holding cash is always a good idea. What you can learn from history and China about playing defense for maximum wealth generation. Ouch. That’s how I felt in 2008 when my portfolio was down 28.6%. The S&P was down 37% that year but I certainly didn’t care about having beaten the market. I’m supposed to be indifferent to how the market is doing and to take a long term focus. After all, that’s what I tell people all the time. But I remember it clearly. I was in Seoul, Korea getting married while the market was crashing. Obviously, I wasn’t concerned because I was sweating bullets while waiting at the altar. Also, being on the other side of the world helps drown out the noise. Then it was straight to the honeymoon and by the time I woke up, the market was in ashes. I was excited though and I had to sneak away to the resort lobby and hurriedly put in some trades before my newlywed wife noticed that I was missing. But despite all that, when 2008 came to an end, my portfolio was hurting by 28.6%. It wasn’t hurt from losing money. The hurt was due to the wasted opportunities I couldn’t take advantage of because I was 100% invested. The Current Situation At the moment, I have 20% in cash which provides flexibility and the opportunity to act if needed. Here’s what Prem Watsa, “Canada’s Warren Buffett”, once said during a conference call about having a high cash position. As far as the 30% cash, remember, that can change. So in 2008, and we had this position in 2007, in 2006. 2008, things turned the financial markets. Stock markets dropped… about 50%… And Tom, the only people who could benefit from that were the people who had cash or government bonds. And so we are conscious of that in our history. Cash gives you options, gives you the ability to take advantage of opportunity but you have to be long-term. We have built our company with a long-term view. Our long-term results are excellent. For example, in 2007, ’08, and ’09, the 3 years, 2007, 2008, 2009, we made $2.8 billion after tax, our book value went up by 150%. Since that time, we haven’t done a lot. But we’ve said to our shareholders that we are long-term focused, our results are lumpy and we never know when it can change. But the cash gives us a huge advantage in terms of taking advantage of opportunity as and when they come. It’s not just in the stock market. People who had the cash to scoop up cheap real estate, businesses or even liquidated inventory to flip have all done well while other people were running scared. Warren Buffett says something similar. We always keep enough cash around so I feel very comfortable and don’t worry about sleeping at night. But it’s not because I like cash as an investment. Cash is a bad investment over time. But you always want to have enough so that nobody else can determine your future essentially. So are you 100% invested or do you have some room to take advantage of opportunities if it comes up? Are you willing to sacrifice 1-2% in potential returns by holding cash, or are you trying to squeeze out every basis point possible without considering what could happen? Cash Does Nothing and Is a Bad Investment True. If you’re talking about a long term horizon greater than 10 years, that is. Holding cash isn’t a popular choice because you feel like you are missing out on opportunities while everyone else is making money . Instead of holding cash, financial commentators prefer to recommend defensive companies, even after the stock market plummets when fear is supreme. But that’s the worst time to be buying defensive stocks anyways because everyone else is thinking the same thing. Plus, it assumes you have the cash to buy defensive stocks to begin with. If cash isn’t your thing, then the next best thing would be rebalance your portfolio from speculative growth picks to recession proof businesses and sleep well at night. Ditto. Learn from History and the Current Chinese Market In Howard Marks memo titled “Ditto”, there’s a section that outlines the cycle in attitude towards risk. 1. When economic growth is slow or negative and markets are weak, most people worry about losing money and disregard the risk of missing opportunities. Only a few stouthearted contrarians are capable of imaging that improvement is possible. 2. Then the economy shows some signs of life, and corporate earnings begin to move up rather than down. 3. Sooner or later , economic growth takes hold visibly and earnings show surprising gains. 4. This excess of reality over expectations causes security prices to start moving up. 5. Because of those gains – along with the improving economic and corporate news – the average investor realizes that improvement is actually underway. Confidence rises. Investors feel richer and smarter, forget their prior bad experience, and extrapolate the recent progress. 6. Skepticism and caution abate; optimism and aggressiveness take their place. 7. Anyone who’s been sitting out the dance experiences the pain of watching from the sidelines as assets appreciate. The bystanders feel regret and are gradually suckered in. 8. The longer this process goes on, the more enthusiasm for investments rises and resistance subsides. People worry less about losing money and more about missing opportunities. 9. Risk aversion evaporates and invests behave more aggressively. People begin to have difficulty imagining how losses could ever occur. When you look at how Howard Marks explains this cycle, it’s clear that history may not repeat, but it does rhyme. And it’s currently rhyming in China. (click to enlarge) My mother-in-law theory is that when my mother-in-law wants to get into the stock market or starts to recommend stocks as an investment, it’s time to move to cash. That’s what happening in China though. But look to history. (click to enlarge) The US market is different to the Chinese market, but it’s a lesson nonetheless and something to keep at the back of your mind. How Far Will the Market Continue Going Up? I consider myself an optimistic person and many times, it has worked against me. A lot of the times, I don’t want to think about the bad things that could happen and I end up pushing it under the bed. And this market isn’t easy to invest in. Most hedge funds aren’t even in positive territory after fees this year. But will the market continue to go up forever? Don’t think so. There has to be a crash correction. My way of playing defense is to be alert and not contempt. I don’t trust or listen to market news or forecasters because they are just as clueless as me about what the market will do next. All I can say about forecasters and market predictions is to quote the following. There are two kinds of forecasters: those who don’t know, and those who don’t know they don’t know. – John Kenneth Galbraith How Do I Play Defense? Here’s how I do it. I’ve printed out Seth Klarman’s thoughts on holding cash and read it regularly or whenever I feel like I’m missing out. Read Howard Marks memos, Buffett letters and other papers and book on behavioral finance. I highly recommend What I Learned Losing a Million Dollars . It’s one of those books that make you grow. But reading books outside of investing keeps me fresh and always provides new insight on how I can improve. I don’t talk about stocks with non value investing people, which means I never talk about stocks at all in day to day life. Maintain a buy list. Remind myself to stop overpaying because valuation matters more than ever . There is a time for offense, but right now, I’m playing more defense. Offense wins games, but defense wins championships. So where are you at the moment? Offense or defense? Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

The Low Volatility Anomaly And The Delegated Agency Model

Summary This series offers an expansive look at the Low Volatility Anomaly, or why lower risk stocks have historically produced stronger risk-adjusted returns than higher risk stocks or the broader market. This article hypothesizes that the combination of a cognitive bias and an issue around market structure could contribute to the Low Volatility Anomaly. This article covers a deviation between model and market that may contribute to the outperformance of low volatility strategies. In the last article in this series , I demonstrated that the aversion of certain classes of investors to employing leverage flattens the expected risk-return relationship as leverage-constrained investors bid up the price of risky assets. In addition to the inability to access leverage for long-only investors, the typical model of benchmarking an institutional investor to a fixed benchmark (i.e. the S&P 500 represented through SPY ) could also potentially produce a friction to exploiting the mispricing of low volatility assets (represented through SPLV ). If a security with a beta of 0.75 produces the same tracking error as a security with a beta of 1.25, investors may be more willing to invest in the higher beta security with the belief that it is more likely to generate higher expected returns per unit of tracking error. In this framework, if the investor believes that the higher beta security is going to deliver 2% of alpha and that the higher and lower beta assets are going to have the same tracking error relative to the index, then the investor would not purchase the lower beta asset unless it was expected to earn alpha of more than 2%. An undervalued low beta stock with a positive expected alpha, but an alpha below the expected alpha of a higher beta stock with an equivalent expected tracking error, would be a candidate to be underweight in this framework despite offering both higher expected return and lower expected risk than the broad market. This investor preference results in upward price pressure on higher beta securities and downward price pressure on lower-beta securities that could be a factor in the lower realized risk-adjusted returns of higher beta cohorts depicted in the introductory article in this series . In a foreshadowing of the next article on the potential influence that cognitive biases have on shaping the relationship between risk and return, the difference between absolute wealth and relative wealth could be an important distinction that influences the behavior of delegated investment managers. Richard Easterlin (1974) found that self-reported happiness of individuals varied with income at a point in time, but that average well-being tended to be very stable over long time intervals despite per capita income growth. The author argued that these patterns were consistent with well-being depending more closely on relative income than absolute income. This preference for relative outperformance rather than absolute outperformance may signal why some managers think of risk in terms of tracking error rather than absolute volatility. In perhaps a more salient example, Robert Frank (2011) illustrated the relative utility effect through an experiment that showed that the majority of people would rather earn $100,000 when peers were earning $90,000 than earn $110,000 when peers were earning $200,000. Among the assumptions underpinning CAPM is that investors maximize their personal expected utility, but these studies suggest that investors in effect seek to maximize relative and not absolute wealth. Similar to leverage aversion detailed in the last article, the preference for relative utility could be another CAPM violation that contributes to the Low Volatility Anomaly. Gauging performance versus a benchmark is a form of maximizing relative utility, and has become an institutionalized part of the investment management industry perhaps to the detriment of the desire to capture the available alpha in our low beta asset example. I am not trying to minimize tracking error in my personal account, I am trying to generate risk-adjusted returns to grow wealth over time. As I have demonstrated in this series, academic research has shown that low volatility stocks have outperformed on a risk-adjusted basis since the 1930s. Disclaimer My articles may contain statements and projections that are forward-looking in nature, and therefore inherently subject to numerous risks, uncertainties and assumptions. While my articles focus on generating long-term risk-adjusted returns, investment decisions necessarily involve the risk of loss of principal. Individual investor circumstances vary significantly, and information gleaned from my articles should be applied to your own unique investment situation, objectives, risk tolerance, and investment horizon. Disclosure: I am/we are long SPLV, SPY. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.