VIX and More

A reminder that the December issue of Expiring Monthly: The Option Traders Journal was published yesterday and is available for subscribers to download.

This month’s issue has a feature article from Mark Sebastian on the future of options exchanges. On a related subject, Mark Longo interviews Gary Katz, President and CEO of the International Securities Exchange (ISE).  Additional subjects covered in the magazine include how market makers use volatility to update their quotes, delta hedging, analyzing opening gap tendencies, payment for order flow, directional vs. non-directional strategies, the role of luck and skill in trading, and a review of Ron Ianieri’s recent options book.

I contribute two articles to the December issue. Unintentionally blurring zoomorphism with mythology, one article is based on a trade I call “the Minotaur” while the other has earned the name of “the Swan Catcher.” The Minotaur turns out to be a VIX-VXX pairs trade and here I embark on a proof-of-concept approach. The Swan Catcher trade also represents something of a bottoms-up approach to developing options strategies. In part one of a two-part series, I seek a way to structure options positions to profit from extreme moves in the market, without losing too much money while one waits for these events to occur.

As is now my habit, I have reproduced a copy of the Table of Contents for the December issue below for those who may be interested in learning more about the magazine. Thanks to all who have already subscribed. For those who are interested in subscription information and additional details about the magazine, you can find all that and more at http://www.expiringmonthly.com/.

Related posts:

• Expiring Monthly November 2010 Issue Recap
• Expiring Monthly October 2010 Issue Recap
• Expiring Monthly September 2010 Issue Recap
• Expiring Monthly August 2010 Issue Recap
• Expiring Monthly July 2010 Issue Recap
• Expiring Monthly June 2010 Issue Recap
• Expiring Monthly May 2010 Issue Recap
• The Education of a Trader (from the May 2010 issue)
• Content Update
• Expiring Monthly: The Option Traders Journal Launches Today
  

I thought I’d spare everyone a silly sounding name like “the VIXies,” so without further ado, here are the highly subjective and not-otherwise-nicknamed VIX and More volatility awards for 2008:

• Best New Volatility Index: India VIX
  
  
• Best New Volatility Product: VIX Binary Options
  
  
• Best New Free Volatility Tool: International Securities Exchange’s Quotes/Volatility Chart and Information
  
  
• Best Previously Ignored Volatility Indicator: TED Spread
  
  
• Best New Blog with a Volatility Focus: Don Fishhback’s Market Update
  
  
• Best New Volatility Webcast: optionsMonster’s Volatility Sonar report
  
  
• Top Volatility Event: Lehman Brothers Failure
  
  
• Best New Volatility Book: The Volatility Edge in Options Trading: New Technical Strategies for Investing in Unstable Markets – Jeff Augen
  
  
• Best Volatility Trade of the Year: SPX Options Carpet Bomb on October VIX Expiration (124% and $180+ million in four trading days)

I’m sure I overlooked some other obvious awards. Feel free to add to this list in the comments section.

The International Securities Exchange (ISE), which publishes a superb implied volatility chart that I have featured on VIX and More on a number of occasions, has recently launched an enhanced version of their IV chart. The new version of this chart, which I have appended below, adds an “ISEE value” to the list of data. I have discussed the ISEE call to put ratio frequently in this space in the past. In this incarnation it is simply a ratio of call volume to put volume for the specified security.

I chose Citigroup (C) as my example security because all eyes should be on this bank, which is now trading at a 14 year low after hitting 3.57 earlier this morning. If Citigroup crumbles, it will dwarf the chaos created by AIG and Lehman Brothers.

Finally, for more information on the company that is the source of the volatility charts used by the ISE, check out Livevol.

[source: International Securities Exchange]

The table below shows call and put activity at the International Securities Exchange (ISE) during the first two hours of today’s trading. Keep in mind that the ISEE is a “call to put” ratio, not the “put to call” ratio reported by the CBOE.

As reflected in the table, right out of the gate there was a flood of calls for indices, ETFs, and individual stocks. Note that in the last hour or so, the activity has tilted heavily toward the put end of the spectrum, as the call to put ratios have dropped dramatically. It is difficult to differentiate between hedging and speculation in these transactions, but now that options spreads seem to be tightening and implied volatility is dropping sharply, I suspect those looking to get short financials and any other part of the market may be leaning toward puts.

It will be interesting to see how the options market is affected by the new shorting regulations.

[source: International Securities Exchange]

I just mentioned RKH, the HOLDRS regional banking ETF, on Wednesday in Regional Banking Woes Worsen, where I also posted a graph of RKH’s six month stock price and 30 day implied volatility.

I am revisiting RKH today with a slightly different chart, also courtesy of the ISE, that compares RKH’s implied volatility and historical volatility over the past six months. In the chart below, notice that the implied volatility in this ETF has been more of an uptrend than the spike from mid-March. Notice also that implied volatility appears to have hit a plateau and is still far below the mid-March peak.

Also of interest, the gap between implied and historical volatility is at a six month high right now, as historical volatility has been trending down over the past three weeks at the same time implied volatility has been trending up.

Finally, note that in those instances where historical volatility has been elevated, it usually preceded a drop in implied volatility; conversely, where historical volatility has been depressed, this has a tendency to precede an uptick in volatility. Volatility extremes often signal turning points. Whether the current high implied volatility and low historical volatility means that the regional banks are finally bottoming remains to be seen, but I have to believe that the probability of a bottom is increasing with each volatile session.

When it comes to implied volatility charts, I normally use the charts from two of my favorite options brokers: thinkorswim and optionsXpress. On the other hand, this blog is littered with IV charts from iVolatility.com, largely because these charts are freely available on the web and because the look and feel is relatively clean and uncluttered.

For a visual change of pace, I suspect I will soon start posting some of the excellent thinkorswim charts, but for those wishing to roll their own, I want to offer a strong recommendation for the implied volatility charts put out by the ISE. When it comes to the ISEE charts on the ISE site, I am often frustrated by the poor graphics, but the ISE charts for individual securities are excellent. An example of one of the ISE’s volatility charts is the one I have included for XLF below. These charts can be customized to a time frame of 3 months, 6 months or 12 months and allow users to specify, via check boxes, any of stock price, implied volatility, and 30 day historical volatility (I have historical volatility turned off here.) As you can see from the graphic below, there is a lot of information crammed into these charts, including daily stock and option volume (easier to read in the shorter time frames), as well as a fair amount of volatility data. All data is delayed by 20 minutes, but as far as I am concerned these are the best free volatility charts out there.

To generate your own volatility charts at ISE, try their Quotes/Volatility page.

[source: International Securities Exchange]

Today the CXO Advisory Blog is out with an assessment of the predictive value of put to call ratios for individual stocks. Drawing heavily on Jun Pan and Allen Poteshman’s 2006 “The Information in Option Volume for Future Stock Prices” from The Review of Financial Studies, the folks at CXO conclude that put to call ratios have “significant predictive power for individual stocks.” Unfortunately, there is a qualifier that “this effect relates predominantly to data that is not publicly available.” [underline in original]

While I support these conclusions, I would not be so quick to be deterred by the qualifier. In “How to Find the Earnings Spiker Before the Announcement” I highlighted the put to call ratio for individual stocks as a key component of the screening formula and provided a link to the SchaeffersResearch.com page where you can find the appropriate charts and data. This data is both public and free; you can’t beat that.

There is also a subscription service from the ISE called ISEE Select that the exchange describes as a “trading tool that uses proprietary call/put trade data from the ISE to identify bullish and bearish sentiment for individual securities.” The ISE goes on to explain that ISEE Select “allows subscribers to retrieve intraday and historical call/put values for securities whose options are traded on ISE.” For the record, I intend to give ISEE Select a try shortly and will be glad to provide my thoughts about the value of this service in this space. In the interim, interested parties may want to check out ISEE Select services and pricing, as well as their FAQs.

I am the first to admit that I intentionally give the ISEE top billing when it comes to put to call sentiment indicators. I should also point out that I am probably in the minority in doing so. I have spelled out my reasons for favoring the ISEE in the past, but today I am going to focus on a better known alternative, the CBOE’s equity put to call ratio.

I discussed the CBOE’s equity put to call ratio back in “A Sentiment Primer,” but I am returning to it today for a two reasons:

1. it is much more widely followed than the ISEE;
   
   
2. it is in the process of printing a significant bearish signal

Starting with the first point, the ISEE was officially launched on December 1, 2003, but the International Securites Exchange (ISE) has data going back to October 1, 2002. On the other hand, the CBOE has historical put to call data going all the way back to 1995, which means that for many years traders standardized on the CBOE put to call ratio and used it as their sole source for put to call sentiment data. Not surprisingly, the combination of a deeper historical database and longer personal experience with the data means that many still use the CBOE data today out of habit.

I should probably mention that the CBOE did not break out the equity put to call and index put to call data until October 21, 2003, but by this time they were already the well established leader and the ISEE has been playing catch up ever since.

Now to the more important part.

As the graph below suggests, when the 10 week SMA of the CBOE equity put to call ratio drops below 0.58, it has generally done a fairly good job of warning of coming market tops. Not only is the current reading down to 0.57, but as higher readings scroll off this week and beyond, you can anticipate that this ratio will go even lower. Should you be concerned? Well, even if you don’t put any stock in these types of ratios, be wary of those market watchers who do – and are prepared to take action.

If you wish to watch the equity put to call ratio more closely, SchaeffersResearch.com has a nice graph tool to play with and a data/graph snapshot to watch. StockCharts.com also has a much more comprehensive gallery graph for non-subscribers. Manic depressive traders (I know you’re out there) will probably prefer to get half hourly updates directly from the CBOE.

I briefly touched upon the ISEE yesterday; and while the ISE web site has a nice little graph of the ISEE going back a year, it is probably not sufficient to answer even the more casual questions about the usefulness of the index. Fortunately, the ISE has data going back to October 2002 available to download so that you can conduct your own analysis…or you can just keep reading.

For now I’m going to skip over the details of the debate about the usefulness of put to call ratios to help call market turns. If you want to do some research on this indicator, a good place to start would be Bill Rempel’s “The Significance of the Equity Put to Call Ratio” commentary at MarketThoughts.com.

Suffice it to say that I believe that it is worth the effort to watch this contrarian sentiment indicator and suggest that a good place to do so is the SchaeffersResearch.com page that graphs the CBOE equity (non-index) put to call ratio. You can create your own CBOE put to call charts at Stockcharts.com using $CPCE as the equity put to call ticker, $CPCI for the index put to call ticker, and $CPC for the total equity + index data.

The ISEE is actually a call to put ratio based entirely on purchases of calls and puts in which a customer is opening a position through the ISE itself. For more details and a testimonial of sorts I recommend a Wall Street Journal article by Mohammed Hadi.

What do the ISEE data look like? I have graphed the 10, 20 and 100 day SMAs going back to 2002. They show a mean of 154, with obvious extreme readings falling conveniently at round numbers: below 100 and above 200. As a contrarian indicator, a reading of 100 or below is a good cutoff for overly bearish sentiment and a high likelihood of a bullish move ahead; 200 signals extreme bullishness and an increased chance of a bearish turn in the markets in the near future. In many respects, a high ISEE number is a lot like a low VIX number and vice-versa.

Turning to the ISEE as a predictor of future market performance, this is a subject that I will come back to regularly in this space, but for now I have posted a graph of the SPX and the 10 day SMA of the ISEE for the period 10/1/02 to 3/19/07. Note that the four largest spikes in the ISEE all preceded significant moves down in the SPX; also, low ISEE readings frequently marked the beginning of bullish moves.

Before wrapping up this subject for today, I will leave the reader with one last thought: the lowest 10 day SMA ever recorded for the ISEE was an 87.00 last Thursday.

I was away for the weekend and am still catching up in my reading, but it looks like Brett Steenbarger saved me a post on the abnormally low put to call ratios.

According to Dr. Brett, Jason Goepfert’s SentimenTrader.com apparently has a more in-depth discussion of the put to call issue. I should add that I am not a subscriber to SentimenTrader, but have had it on my To Do list for a couple of months.

Finally, some of the more observant readers may have noticed that I added a link to the ISEE at the upper right hand corner of this blog last week. The ISEE is a sentiment index (in this case, a ratio of call to put options, multiplied by 100) compiled by the International Securities Exchange or ISE. In some respects, it is similar to the put to call ratios at the CBOE, but without the heavy institutional action in the indices that tends to dominate the activity on the CBOE.

I have been looking hard at the ISEE in the past week because of the unusually low readings, including consecutive all-time lows (data go back to 2002) in the 10 day SMA last Wednesday and Thursday.

Stay tuned for more on put to call data, what it means, and its predictive power.

In the rush to capitalize on the sudden volatility in the markets, many have jumped in to buy VIX calls not fully realizing what they were getting in to. Adam Warner summarizes Barron’s take on some of the shortcomings of VIX options as an investment vehicle and reiterates his own perspective, which is essentially that the more sensible and direct play is SPY options. For the record, I am in agreement here and have stated some other reasons why VIX options may not be appropriate for all by the most experienced options traders.

Here is another way to play volatility without even resorting to options or ETFs: the exchanges. CME just reported record options volume in February and will likely continue to be a beneficiary as concerns about increased risk and volatility create new demand for derivatives to reduce risk and volatility going forward. This morning, CME is down more than 50 points from the January high of 596.

Another options exchange play is ISE. This smaller electronic options exchange had a strong February, but has more question marks than its larger rivals. ISE is down about 12% since February 23^rd and may be an attractive takeover target.