We Have a New Indicator
Our indicators are in neutral territory, but we know that you’re all itching for a new trade. Our solution? To create a new indicator for something that is not neutral.
And so we welcome a new indicator to our fold, one that’s a bit different from our others. It measures the likelihood of change in the VIX, a measure that is derived from option premiums on SPDR S&P 500 ETF (NYSE: SPY) contracts and is widely used to assess how investors view market volatility.
Without getting too technical, an option premium is just the value of an option above its intrinsic value. With an out-of-the-money option, the entire option price is the premium. For an in-the-money option, the premium is the difference between what you pay for the option and its intrinsic value. For example, if you pay $700 for one option contract (one contract is equal to 100 shares of the underlying security) with a $65 striking price, the intrinsic value is $500 and the premium is $200.
Option premiums vary with time – in general, the longer to expiration, the greater the premium. Likewise, the longer to expiration, the greater the variability in economic variables from interest rates to growth expectations.
Intrinsic values are not volatile. They always are just a fixed arithmetic relationship between the strike price and the price of the option. Premiums, however, change based on how volatile traders expect the market to be. The value of VIX reflects this expected volatility.
Because markets tend to be more volatile on the downside – i.e., on average downside moves tend to be more sudden and larger than upside moves – there is a correlation, a negative one, between VIX and market changes. In our case the correlation between our SPY indicator and VIX indicator is about minus 0.70. That is relatively high but not so high that it precludes the two indicators from giving different signals. (Keep in mind that a correlation of plus or minus 0.70 means that less than half the variability or variance in the indicators overlap).
On Wednesday our VIX indicator is indicating rising volatility, while our SPY indicator is neutral. Since rising volatility tends to raise the premiums on all options, both puts and calls, our bet was both a put and call. The call was dated January because we wanted to get a seasonal edge. Depending on how the two indicators – the SPY and the VIX – change, we may get out of one side or the other or both at virtually any time.
You might ask why we’re not buying options directly on the VIX, since VIX options are offered. The reason is that unlike stocks, where an intrinsic value is theoretically a function of the stock’s underlying fundamentals and can be separated from the premium, for the VIX the intrinsic value and premium can’t be separated. This means at different months there are different assumptions about how volatile the market will be – assumptions about interest rates, inflation, and any other variable than can make a market volatile – and these assumptions determine both the intrinsic value and the premium.
For example, currently the VIX is at about 9.7, representing a complex weighted average of premiums on both SPY calls and puts, yet the $12 put for October is trading at a higher price than the January put option. The reason is that the market expects VIX to be higher in January that it is today.
Our indicator doesn’t reflect current market expectations about changes in volatility but rather how these expectations will change over time. So theoretically we could pick any future striking price and sell a put or buy a call and it would be consistent with our indicator’s reading. However, that would raise the specter of major disappointment on the part of holders in that the VIX could rise and indeed rise pretty sharply without a commensurate move in the option. It would also limit our flexibility in reacting to changes in our SPY indicator, which, in a nutshell is why we chose the calendar straddle – it’s a clear bet on rising volatility but gives us flexibility at the same time.
We’re happy to answer any questions on this that any of you might have. As for our other indicators, as we said all of them currently are in neutral territory, but it’s noteworthy that both gold and gold stocks have begun to improve. If this trend continues, we will have a gold trade in the not-too-distant future.