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Barron's Online - The Striking PriceThe Volatile Truth
A low VIX isn't always a sell signal
By Erin E. Arvedlund
Does the low level of the VIX, the Chicago Board Options Exchange's
volatility index, signal that the stock market is likely to decline?
The VIX, a widely watched gauge of investor sentiment, measures volatility
of Standard & Poor's 100 index options. Expressed as a number, the VIX tends
to spike amid market panics. Ever-contrarian option traders view a high VIX
as a bullish indicator, and generally bet against the fear infecting the
Wall Street herd. (Hence the old saying "When the VIX is high, it's time to
buy.") Conversely, when the VIX drops, pros believe that investors are too
complacent. The conventional wisdom on Wall Street is that a low VIX means
the stock market is due for an implosion.
Not so fast. As a market-timing tool, does the VIX actually predict the
direction of stock prices? A new report by Merrill Lynch's
equity-derivatives strategist Benjamin Bowler tried to determine whether the
VIX historically has been a good predictor of future equity market returns,
by finding cases where the VIX hit recent lows and tracking the market in
subsequent periods.
What Bowler found was surprising: The VIX is more reactive than predictive.
Changes in investor sentiment are priced into both equity and options --
simultaneously. "I'm not convinced the options market prices in risk not
already priced in to the stock market," says Bowler.
So can the VIX predict future returns? "The evidence is very poor," Bowler
concludes. Since 1986, in 59% of cases when the VIX fell to a relative
one-year low, the S&P 500 actually rose during the following one-month
period. The same pattern holds for one week, as well as three-month,
six-month and 12-month returns. "While some might feel that the VIX has been
good at forecasting market turns -- the VIX had fallen significantly prior
to the market peaking in August of 2000 -- we find that since 1998, in only
three out of five cases did the market fall in the one-month period
following the VIX hitting a relative low."
So what can investors glean from watching the VIX, or volatility measures
such as the VXN (CBOE-Nasdaq volatility index) or the QQV (the AMEX-Nasdaq
volatility index)? Long term, the VIX should reflect lower technology
weightings in market indices. "The bubble in tech to some degree translated
into a bubble in volatility," Bowler adds.
But as a short-term tool, Larry McMillan of McMillan Analysis looks at the
VIX this way: "When volatility is low, one cannot know whether the market
will rise or fall -- only that it will be volatile."
There seems to be little disagreement over one fact: when volatility has
spiked, as it did in 1987, amid the Asian crisis, and after Sept. 11, the
market rises. But when volatility is low, "the market does not necessarily
decline. It only does so about half the time," McMillan says.
Moreover, if volatility is low, investors get complacent, but they don't
necessarily think the market is going up. Rather, they think it's going
nowhere. Taken to its logical conclusion, a low volatility reading actually
signals the public does not expect the market to move much in the near
future at all.
Hopefully, this helps debunk the Wall Street myth that low volatility always
precedes falling prices. Sometimes it does (especially in the last two
years, where huge moves occurred), but most often it does not. Low
volatility does precede a volatile market.
By extension, in low volatility periods, investors who traditionally run out
and buy put options as insurance against a decline should consider buying
straddles, which profit from big price swings in either direction.
Repeat Offenders
Mika Toikka, the head of options strategy at Credit Suisse First Boston, has
a list of what the firm calls "repeat offenders" -- companies at risk of
issuing earnings warnings, quarter after quarter.
Based on this, CSFB came up with candidates likely to pre-announce yet
again, and from those culled out stocks with "cheap" options worth buying
ahead of earnings season.
CSFB recommends buying one-month or two-month, at-the-money put options or
put spreads on Texas Instruments, American Express, Bank of New York,
Altera, Phelps Dodge, May Department Stores, UST, Gillette, FleetBoston
Financial and Knight Ridder.
In a put spread, an investor buys one put and sells another put at a lower
strike price. Both put options have the same expiration date.
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