The Lawrence Chan Blog

30-minute S&P 500 charts presented without comment.

Year 2000 Jan chart.

Year 2014 so far.

Coincidence?

No comment yet

I was informed earlier today our historical data bank has been a success (good news!) and that causes overload on our web servers several times (damn!).

I have decided to move on to use special file servers to host our data. This transition will take at least several days to complete. Please understand that it is necessary because going forward as we expand into providing daily updates of our customized breadth data for indices and forex pairs it will be too late to correct the delivery mechanism.

This should not affect my plan to introduce the first batch of custom breadth data this weekend.

No comment yet

Majority of option traders who understand options tend to focus on the mathematics of VIX while the chart traders who trade S&P 500 Index futures tend to focus on the chart patterns and confirmation signals from VIX.

Who is right?

Who understand VIX better?

Here is a short piece on the VIX Phenomenon that no one in the financial blog sphere ever talked about. Maybe learning something about VIX from a completely different perspective all together can help us answer the questions above.

CBOE Volatility Index

VIX is the symbol for CBOE Volatility Index. I am not going to waste time here discussing what it is. You can find out more about the index at wikipedia. Links are provided below for further reading.

The one single most important key about the VIX value itself is that it is an annualized rate of the expected variance of the S&P 500 based on the nearest traded strikes of the SPX options.

Thus the value of VIX cannot be directly translated into the expected volatility until you plug the value into a formula to get the estimated standard deviation of the period you are interested in. The calculation method is quite simple. There is an example in wikipedia illustrating the method so I am not going to repeat that here.

Let’s dive in to the heart of the issue.

The VIX Phenomenon

Following is a table of VIX levels with the corresponding implied 30 days percentage change and the translated absolute value at 100 points interval based on S&P 500 price levels. If you do not understand what I mean in the first sentence, it is okay. Let’s look at the table first and I will explain right after.

When VIX is at 13, the 30 days estimated volatility is 3.75% and that translate into 45 S&P points if S&P is trading at 1200. If S&P is trading around 1800, that translates into 67.55 points. These absolute values carry a lot of weight. They are there telling you that if S&P is trading at 1200 with VIX at 13, there is a 65% chance S&P is going to stay within +/- 45 points from 1200. If you trade options, you must know this to formulate your strategy properly.

So many numbers in a huge table. What’s the point?

I have computed the average value of VIX since 1997 at each 100 point interval on the S&P 500. It is the 2nd line from the top of the table. For example, when S&P was trading at 1200 +/- 50 points, the average value of VIX was 20.4 since 1997.

Looking at the numbers themselves it is not easy to draw a connection. So, I have highlighted these average VIX levels in yellow corresponding to the respective S&P price levels. Now, they are very interesting.

The higher volatility readings at 1200 to 1500 was mainly due to the steep decline and spike values in VIX during the last 2 market crashes. But that does not change the fact that there is a general trend of decline in VIX level relative to the increase in S&P 500 price levels.

Why is it the case?

Keep It Simple Stupid

The clue is the near constant range of the absolute values translated from these standard deviations.

From the 1600 to 1800 column, the absolute value is within a constant range at 65 to 75 S&P 500 points.

If the extreme spikes (value greater than 40) are removed from the VIX historical readings, this constant range will be the same for the 1300 to 1500 columns too.

Traders who trade S&P 500 options, be that used for hedging or pure speculation, do not really depend their final trading decisions on their option models. When things boil down to money making, these traders are really looking for the absolute potential in their trades and adjust the risk they are going to take accordingly. After all, profit and losses are measured in S&P points, not the Greeks in the option price models.

In short, options on index are traded off the absolute value of the indices because human do not trade with unlimited capital and fictitious percentage measures. Humans behave the same way no matter S&P trading at 1200 or 1800. This phenomenon also indirectly shows that majority of volatility models failed to capture the essence of human trading behaviour.

Summary

It is now easy to answer the questions I raised in the beginning of this article.

The option traders more talented in math are blinded by their superior math skills and ignored the fundamental principle of any market. That is, traders are bounded by their profit making objectives and risk profiles. Thus, no matter what they think, VIX has the characteristics of a tradable instrument and it shows in its charts.

The traders who are good at chart reading can often pick up the interesting behaviour of VIX like how it loves to hold a particular level for a long period of time. That is excellent detective work but the lack of understanding the nature of VIX makes it difficult to figure out the reasons behind such phenomenon. In turn, the inference from the observations may not be as accurate as one likes it to be.

Both sides have something to learn from each other.

Resources

CBOE Volatility Index (VIX) at Wikipedia

Bankable ETF Strategy: VIX Rotation

Volatility Snap: VIX Based Always In Trading Model

8 comments

Much has been accomplished last year at DaytradingBias.com. I am glad with the results and is looking forward to take it to the next level. Time to review what has been done last year and what has to be done this year.

Goals Accomplished

Past year I took over the ownership of the site and drew up a plan to revamp the site. The main objective back then was to create an infrastructure to allow the site to host its content and services more efficiently. So far the results are satisfactory.

• Real-time chat room is now totally scalable. It can now handle as many participants as we like
• Review section ready so it is now possible to organize the reviews easily and dynamically
• Forum area created making it easier among members sharing their thoughts and opinions
• Tool set developed making deployment of premium and member content easier
• Art of Chart Reading basically completed
• Historical Data Bank section created with rare to find historical data
• Daily Bias Reporting for both S&P and Forex is now ready

2014 Goals

Like building anything complex, a good foundation has to be created first. The ground works completed in 2013 allow me to spend more time going forward in creating useful content without wasting time on web design and other nuisance. Time to build the castle on top of the foundation, finally.

This year my goals are less aggressive but the benefits they will bring to the members will be much more significant because they are all new services:

• Making custom market breadth data available in Historical Data Bank
• Custom Market Breadth daily charts and bias reporting
• Complete the real-time bias reporting engine
• Beta release of the real-time tools
• Publish more useful day trading bias setups for indices and forex markets
• Chart lessons for Art of Chart Reading

The custom market breadth data, the related research articles and reporting are necessary because they are the unique trading tools that I use giving me the advantage that no one else have. Many very powerful daily and real-time bias I use comes from custom market breadth. It is a good thing to offer the data and my research work to those who are interested in the subject.

In case I have extra spare time on hand, will also look into the following areas as many members already requested for these services to be added over the years:

• Stocks ranking / filtering
• Adding the metal and grain markets to Market Bias Informant
• Video on trading

Limited By Time

One resources I do not have is time. I have other priorities in life so there is only so much time I can allocate to building this website. I consider building this website my hobby so it is actually fun making it work and useful to others. At this point I do not see that I would have more spare time on hand so improvements and new contents for the site will continue to progress at about the same pace.

No comment yet

Google Talk on the book What’s Behind the Numbers by the authors.

Note: It is 1 hour 16 minutes long.

I choose this video because it is a great alternative if you find reading the book is too time consuming.

If you are interesting in trading stocks (and the indices), their work can convince you stop believing in many myths produced by the Wall Street marketing machine.

The question and answer session after their presentation is also a good one.

No comment yet