MSN: "Make volatility and uncertainty your friend", 5/3/01
$VIX:
stockcharts.com[l,a]dholnymy[pa20!a25!a30][vc60]
"Make volatility and uncertainty your friend"
moneycentral.msn.com <---------"VIX Swing System"
"The Education of a Speculator" by Victor Niederhoffer:
shopping.yahoo.com
"Of Play and Money" by Pierre Lemieux:
pierrelemieux.org
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>>>The Speculator
Make volatility and uncertainty your friend
The variables of investing have an indicator: the VIX. Buy when it's high, sell when it's low and our charts say you'll make money.
By Victor Niederhoffer and Laurel Kenner
When fortune means to men most good she looks upon them with a threatening eye.
-- William Shakespeare, "King John," Act 3, Scene 4
Swings in optimism are one of the most notable regularities in market moves. Even a cursory examination shows that key sentiment indicators -- the percentage of bullish advisers, the percentage of advancing stocks, the degree of bullishness and risk in options, and the percentage of cash held by mutual funds -- swing back and forth from high to low like pendulums.
The big question is whether these changes in sentiment have any predictive power vis-à-vis future moves in the general market or individual stocks.
We chose to test this concept by focusing on the predictive properties of the Chicago Board Options Exchange's Volatility Index, or VIX ($VIX.X). This is the average of implied volatilities of short term, at-the-money index options traded at the CBOE. VIX shows the level of variability that the market would have to demonstrate over the next month to make current option prices fair.
We previously reported some results on this measure in December ("Turn a profit when the sky is falling "), when the VIX was unusually high and we were bullish. We will now update these results and report on an elegant, useful and rigorous study by David Simon and Roy A. Wiggins III, "S&P Futures Returns and Contrary Sentiment Indicators," that appears this year in the Journal of Futures Markets.
The normal range for the VIX over the past five years has been 20% to 25%. In general, readings above 30% are considered relatively high and readings under 20% are relatively low. As we write on Wednesday, it stands at 27.5%, down from an inordinately high level of 32.5% just a week ago.
The basic theory
A good working hypothesis is that when the VIX is high, sentiment is unusually pessimistic and it's a good time to buy stocks. Conversely, when the VIX is below 25% or 20%, sentiment is unusually optimistic and it's a good time to sell.
So here's the concept in a nutshell:
It's highly profitable to buy financial instruments that mimic the movement of the S&P 500 Index ($INX) the first time the VIX closes above 30%. And you would sell the first time the VIX closes below 25%. Appropriate instruments would include S&P futures contracts, the Vanguard 500 Trust (VFINX) mutual fund or SPDRS Trust (SPY, news, msgs) shares, referred to by traders as "spiders."
The table below shows that swinging from buy to sell with a system like this yields an average profit of 3.1% on 11 trades in securities mimicking the S&P 500 since October 1997. There were just two small losses among the 11. And the system appears to work fairly well for General Electric (GE, news, msgs), where the average profit has been 5.1%.
VIX Swing System See link above.
How would one use such a system without buying a market index specifically?
When the VIX is above 30%, an investor might wish to become aggressively bullish in volatile stocks or indexes of his or her choosing. During the remaining time-about three-quarters of the days in the past four years -- the investor might wish to become cautious, to the point of staying out of the market.
Simon and Wiggins came to similar conclusions with a separate approach. They looked at the effect on the S&P 500 futures of each percentage point change in the VIX. They concluded that for each percentage point increase in the VIX above its norm, the S&P goes up an extra 0.1% in the next 10 days, compared to normal. Thus if the VIX goes up 10 percentage points to 35% from its norm of approximately 25%, the S&P 500 Index can be expected to go up 1% extra in the next 10 days. Conversely, when the VIX falls 10 percentage points to 15%, the S&P can be expected to fall 1% relative to its normal move.
Simon and Wiggins also show what happens when the VIX is at high levels and at low levels. Most impressive of all, they run what is called an "out of sample test." They demonstrate that with information available to a forecaster at the beginning of each year, a useful forecast could be made. For example, on a prospective basis they came up with 39 forecasts that the S&P futures would go up in the next 10 days. In actuality, 22 of them went up and the average change was exactly as predicted: up 1%. Similar results occur for the occasions when the market was predicted to go up by 3%.
The professors are not the usual run of academics who obscure their results with impenetrable mathematical and statistical gyrations so that the results only become meaningful to a handful of fellow travelers, and reproducible by none.
Perhaps the reason is that Simon, who teaches at Bentley College in Waltham, Mass., has an unusual background for a professor. He actually worked for a hedge fund before going to academia, rather than the much more common reverse situation. The professor is not averse to a bit of trading of his own and is active in individual stock options. Furthermore, Bentley has a trading floor for its students with dozens of workstations and live feeds from all the major data providers that would make most traders green with envy. And the students actually use these machines to answer realistic trading questions that they are assigned in class.
Where we stand
At present, the VIX is exactly in the middle of the bearish and bullish range at 27.5. It is coming off a buy signal on Feb. 23, when it closed just above 30%. Sentiment among investors is decidedly upbeat at present, with the S&P 500 closing at a level not seen since the start of March.
All things considered, the degree of optimism is too high for us, since it borders on the kind of exuberance that has led to agonizing recriminations in the recent past.
Because we write weekly, it is hard for us to fine-tune our predictions. But to the extent that any of you have followed the repeated bullish forecasts that we gave when the market sentiment was quite pessimistic and stocks were regularly setting new lows, we would suggest taking your fortune and converting it to cash equivalents until fortune once again becomes threatening.
At the time of publication, Laurel Kenner and Victor Niederhoffer did not own shares in any of the equities mentioned in this column.<<<
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>>>Published in Discourse (St. Lawrence Institute), Summer 1997, pp. 40-41.
Of Play and Money
by Pierre Lemieux
What does it take to be a successful speculator? If anybody, Victor Niederhoffer should know.[1] Over the last two decades, he has made a fortune speculating on all kinds of financial markets all over the world, out of his base in New York and Connecticut. He was branded the most successful fund manager in 1994.
But in these memoirs of a speculator in his early fifties, Mr. Niederhoffer tells us that humility is a cardinal virtue in his business. He would rather speak of his failures, like when he lost 25% of his assets in one tense hour during the dollar debacle of March 1995. He is often on the verge of financial catastrophe, just as his grandfather, a small-time speculator in stocks, was wiped out in 1929 -- with a lot of larger speculators.
Indeed, not all speculators make money, and the lucky ones don't make money all the time. Niederhoffer's mentor and former employer, George Soros, has been earning a 35% annual return for three decades, but his Quantum Fund lost money in 1996.
Speculating consists in buying low and selling high, but the problem is to know when is low and when is high.
What is the proper education for a speculator?
In this book, we follow the young Niederhoffer from his childhood in Brighton Beach, Brooklyn, in a family of modest means whose head was a New York City policeman, to his college days in Harvard, and his Ph.D. in Finance at University of Chicago. What we discover is an education based on a rich mixture of play and gambling, music and rhythms of life, science and analysis, and competition.
The first shock, perhaps, comes from realizing how much importance the author attributes to play and gambling. His whole childhood looks like a succession of sports events, games, and gambles. But then, it was not wasted fun, as he was young taught, especially by his father (an omnipresent figure), to learn lessons from all experiences.
The book's most intriguing chapter compares market ups and downs with movements in Beethoven's symphonies or Bach's sonatas. Although some of this is written tongue in cheek, the main point lies in the parallelism between rhythms of life in general and speculation in particular.
Now, speculation is more than gambling and music. The speculator performs crucial economic functions and provides a homeostatic mechanism for balancing supply and demand. This ceases to be true when everybody runs with the crowd, but the ensuing bubble can only last so long. At some point in time, contrarians like Niederhoffer will bring the followers back to reality. Hence, the idea of the speculator as a contrarian, which is a watermark of this book.
How does the successful speculator recognize reality, and forecast market evolution, better than others?
One economic answer, related to the theory of efficient markets, is that he cannot, except by gambling and sheer luck. The alternative economic answer is that the speculator is a Kirznerian entrepreneur who discovers and knows things that others do not. Another type of answer comes from financial "technical analysis," which Mr. Niederhoffer rightly discounts as having no scientific basis. Like other gurus' pronouncements, such gadgets have no more predictive power than the Delphic oracles of two millennia ago.
Niederhoffer argues against the efficient market, or random walk, hypothesis: "There is always a market somewhere where divergences can be rectified. But the problem is to recognize a divergence." Markets do show regularities that are amenable to scientific and statistical analysis. Many examples are produced -- like, for example, the statistically significant observation that years ending by "5" tend to be bullish in stocks, while years ending by "7" have fallen in the bearish camp.
Yet change is a constant feature of markets, and many speculators have been wiped out gambling on a repeat of October 1929 or October 1987.
The good speculator understands the deep motives that run the world and can analyze scientifically their changing impacts. Everything is connected. When winds blow more softly in the Pacific, the ocean will warm, anchovy harvests in South America will suffer, supply of poultry and cattle feed will be reduced, and the Niederhoffers of this world will rush to buy grains before their prices jump.
The competitive spirit is another ingredient in the education of a speculator. Niederhoffer's book is full of parallels between speculation and competitive sports -- including squash, in which the author was a North American champion. Competition on financial markets is modeled as an ecological system, but this is probably where Niederhoffer is the weakest. Although he is aware of the danger, the predator-prey model dangerously obscures the difference between a shark eating a small fish, and the advantages of voluntary exchange in human society.
Finally, we don't know what it takes to be a speculator, except that it is related to the range and richness of life experiences and learning, from chess and sex to family life. In any event, the author had warned us that if he did have a recipe to make a fortune in speculation, he would not be foolish enough to reveil it. Like inside information, a good recipe would loose its power once known.
Does Mr. Niederhoffer actually have a recipe? Probably not.
Virtues like a scientific mind, individualism, and self-reliance are necessary, but not sufficient, conditions to prosper as a speculator. They are also general conditions of the good life, as we learn in this brilliant book, written in lively style by one of the most learned businessmen of our times.<<< |
