[RT] Hurst - VIX

["Ray Raffurty" <r.raffurty@xxxxxxxx>]

Hi all RT's,
 
This is a copy of an article sent to me re. the 
relationship between Hurst and the VIX.  Interesting reading.
 
Good luck and good trading,
 
Ray Raffurty
 
 
 

H.E. Hurst became intrigued with the Nile River while a civil servant in 
Cairo in 1908. Actually, it was more like obsessed: His mathematically curious 
mind led him to examine 800 years of flood data on the Nile River basin. He was 
surprised when he noticed in the data that good flood years were generally 
followed by good flood years, and bad years begat more bad years. 
Hurst knew that he was onto something, so he dug in even deeper. In an effort 
to quantify and predict these flood characteristics for reservoir planning, 
Hurst developed his "Hurst exponent", which is an elegant and precise method of 
measuring whether or not there is persistence in a data series. Hurst 
noticed that most natural phenomenon that most thought were random -- like 
rainfall, flooding, sunspots, etc -- were actually persistent, and exhibited a 
"memory effect." In other words, what just happened had a tendency to influence 
what was about to happen.
We all know from first-hand experience that financial markets are persistent 
in just this way. The old truism that "the trend is your friend" turns out to be 
exactly right. Studies on S&P 500 historical data show it to have a Hurst 
Exponent of .78, which means it is highly persistent in its trends, and not 
random at all, as some misguided academics would argue. A Hurst Exponent of .50 
equates to random price movement. 
Interestingly, studies have also shown that this memory effect in the S&P 
500 lasts about 48 months, after which this effect completely diminishes. This 
fits in well with the regular 4 year cycle in the markets.
All markets show varying degrees of persistence. Currency markets are the 
most persistent. Futures traders know this very well, as currency markets often 
show amazing trendiness. This persistence of price is the main reason it's 
generally not a good idea to fight the trend, but much better to just "go with 
the flow."
Interestingly, the rarest thing in financial markets is a trait that is 
anti-persistent -- that is, it tends to do exactly the opposite of 
whatever it just did. It doesn't trend. It oscillates. 
Volatility is anti-persistent, and this is why it's so useful.
Volatility has a strong tendency to revert to the mean. A period of high 
volatility is followed by a period of low volatility. A period of low volatility 
is followed by a period of high volatility.
Here's how this looks on the chart of the S&P 500:
<IMG height=507 alt="[Image 1]" 
src="http://www.21stcenturyalert.com/tcx/images/morningbriefing/2002-08-13/081302atr.gif"; 
width=476>
The VIX also moves back and forth, anti-persistently:
<IMG height=507 alt="[Image 2]" 
src="http://www.21stcenturyalert.com/tcx/images/morningbriefing/2002-08-13/081302Vix.gif"; 
width=476>
This anti-persistence gives us a nice oscillatory path to anticipate for the 
VIX. A technical indicator is only valuable if you have a pretty good idea of 
what it is going to do in the future. With the VIX, we always know that its 
tendency will be to revert back to the mean, and do the opposite of what it just 
did.
This also works so well because high volatility is very much associated with 
price bottoms, and low volatility with price tops. This is not a hard-and-fast 
rule, mind you, but it's definitely an idea that will make you money time and 
time again.
So when we examine the motion of the VIX in real-time, we look for these 
anti-persistent, mean-reverting swings. It's a constant back-and-forth cycle on 
the VIX -- just as the market is constantly in a process of oscillating between 
advance phases and decline phases. Watching these oscillations lets us know 
exactly where we are with the market, in whatever time frame we want to 
examine.
Since price is persistent and trendy, then often a "decline phase" as 
signaled by the VIX won't actually see prices decline, or an "advance phase" 
won't see prices go up. During the bear market, there were often short-term 
advance phases where the market actually declined in price. That's a sign of a 
very persistent downtrend, and a very weak market, by the way. Such divergences 
in price and sentiment are some of the most valuable clues that we can 
observe.
There's obviously more to it than just this, but in a sense it's not 
necessarily beneficial to stray too far away from this picture of the markets I 
just outlined. Sentiment oscillates back and forth between fear and greed, and 
by closely studying the VIX and price we have a way to catalog and examine 
this.






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