they take on more and more shortput positions. As providers of stock market “insurance,” if you will, marketmakers raise their “premiums” as the market falls.Once the market turns up and investors begin to feel more comfortable with their stocks, they stop buying insurance and the VIX drops. Thisdrop is almost always very swift. After having climbed for several days,when the VIX suddenly reverses and starts dropping, this often marks ashort-term, if not an intermediate-term, bottom in the market.We can begin to understand how to recognize VIX reversal patterns bylooking at some examples from a three-month period during the summerof 2001. Four clear examples of VIX top reversals are marked in Figure 8.9.(We’ll examine VIX bottom reversals later. For now, let’s just focus on VIXtop reversals.)The two most important factors in gauging a good quality VIX reversal are that the reversal be preceded by a buildup lasting several days,and that the VIX be above average relative to recent history. You will notice that all four of the marked reversals were preceded by a ramping-upperiod lasting several days, and culminated with the VIX peaking at
ccc_yates08_161-184.qxd 6/4/03 1:36 PM Page 170
170
ENCORE
above-average levels. That is why I marked only these four reversals.Other reversals occurred during this time. For instance, one occurredlate in June and another on the seventh trading day in August. Thesewere notable, but not of the highest quality.I would also call your attention to the fact that the VIX gapped up onthe open on every one of the four best VIX reversal days. That very oftencharacterizes the top day.After noting a rising for several days, reaching a relative extreme, Ilook for a 3 percent retracement off the high. I have found that a 3 percentretracement is just about optimal for triggering a signal. In other words, Ilook for the VIX to make a high, and then pull back 3 percent from there.(That’s 3 percent, not 3 points. For instance, if the VIX peaks at 36, I’ll belooking for 36 × .97 = 34.92.) The high need not have been set today; it mayhave been set on the previous day.Figure 8.10 shows a chart of the S&P 500 index (SPX) during the sameperiod. All four of the most notable VIX reversals coincided with shortterm market bottoms, although after the fourth VIX reversal, the marketwafﬂed for three days and then went up for one day, so in that case therally was not as crisp as we would have liked.The VIX peaks when the market hits bottom, and the VIX bottomswhen the market hits a short-term top. Thus you could say that the VIX is acoincident indicator, because the VIX hits its top, and the market its bottom, on the same day. Although the VIX is not a leading indicator, it is valuable because of the way it moves to short-term relative extremes and thenreverses. A chart of the VIX speaks to us in ways that the price chart cannot. When the market is dropping day after day, and you’re in the midst ofit, trying to ﬁgure out exactly when to cover your short position, it can bepretty hard to tell just by looking at the price chart. But take a look at theVIX chart, and you can get a good idea.To illustrate how strongly the VIX can signal a bottom, let’s take a lookat what the market and the VIX looked like on the morning of July 24,2002—at the culmination of a dramatic sell-off. The charts in Figures 8.11and 8.12 were taken at 9:30 A.M. CST that day—one hour into the tradingday. In other words, the ﬁnal bar in this pair of charts represents just onehour of trading.After climbing for days, the VIX gapped open into the upper 50sand was starting to come down. The market itself had opened lower andwas coming back. The VIX was giving us a high quality signal, and thestage was set for a powerful rally. Indeed, the Dow ﬁnished up 489points that very day, and advanced another 500 points during the next 3trading days.A VIX top reversal is not only a signal to go long, but also a signal toclose out any short positions I may be holding at the time. I know of
ccc_yates08_161-184.qxd 6/4/03 1:36 PM Page 171
Timing the Market Using the VIX
171
FIGURE 8.9 VIX Top Reversals
FIGURE 8.10 Corresponding Short-term Market Bottoms on S&P 500
no better signal for exiting a short position than a VIX reversal signal togo long.While others who espouse VIX reversal trading recommend taking aposition at the close of the VIX reversal day, I prefer entering during theday. Many times the VIX reversal day is characterized by the marketdropping sharply and then recovering sharply before the close. I enjoygetting in on that day’s action.
ccc_yates08_161-184.qxd 6/4/03 1:36 PM Page 172
172
FIGURE 8.11 Price Chart—Market Dropping
FIGURE 8.12 Price Chart—VIX Rising
ENCORE
ccc_yates08_161-184.qxd 6/4/03 1:36 PM Page 173
Timing the Market Using the VIX
173
VIX Bottom ReversalsJust as VIX top reversals signal market bottoms, VIX bottom reversals often signal market tops. However, VIX bottom reversals can be more difﬁcult to recognize. That’s because as the VIX settles down into lower levels,it tends to trade in a narrow range. While VIX top reversals practicallyjump right off the page, VIX bottom reversals are more subtle, and can bedifﬁcult to recognize until after they are past. So you have to tune in moresensitively to VIX bottoms. However, if you’re too sensitive, a fake signalcan get you into a short position too early. Interestingly, however, in myback-testing even short positions entered too early worked out eventually,if you had the courage to stay through the market moving the wrong wayfor a few days.Again, you would want to see the VIX trend downward for severaldays and go beneath recent average levels. After setting a low (either today or yesterday), you would look for the VIX to make a 3 percent reboundoff that low. While VIX tops are often characterized by a gap opening, Idon’t usually expect to see that with VIX bottoms.As VIX bottoms are more subtle and difﬁcult to recognize, that leadsto what seems to be a weakness in the system—that it can give too manysignals to go short, causing you to get short too early sometimes. In mysimulations and back-testing, I came across a period in early 2002, for instance, where my system gave four short entry signals before giving a longentry signal (see Figures 8.13 and 8.14). If I was following this system, Iwould have gotten short on the ﬁrst signal and held it all the way through.Since it’s best to hold a short position all the way to the next long signal,this position would have been held for more than a month and would havebeen proﬁtable at the end.However, the ﬁrst and second signals were not optimal, as they weretoo early. So, naturally, I thought of tightening the model to try to eliminatethe early short signals while keeping the good short signals. However, Ifound that tightening up the entry parameters did not help, since eliminating the early signals also eliminated the good signals.I have tried working on a variety of early exit rules for stoppinglosses on short positions. Surprisingly, any change only made the resultsworse overall. It turns out that it is always best to see the positionthrough, as the market always turned down and the short position eventually became proﬁtable.Note that I was back-testing only a 1.5-year period ending in September2002—a bear market. The model and the parameters might need adjustingwhen we go into a bull market. In general, I don’t expect VIX reversal trading to work as well in a bull market because of the false short signals thatmay come up. But those short signals shouldn’t be ignored because, even in
ccc_yates08_161-184.qxd 6/4/03 1:36 PM Page 174
174
FIGURE 8.13 Four Short Entry Signals
FIGURE 8.14 VIX Bottom Reversal—Four Short Entry Signals
ENCORE
ccc_yates08_161-184.qxd 6/4/03 1:36 PM Page 175
Timing the Market Using the VIX
175
a bull market, there are brief, nasty little sell-offs. And you can make a lot ofmoney if you can time those pullbacks.
Exit Rules for Long PositionsThe exit rules for long positions are not what one might expect. In an uptrending or sideways market, hold for four days. Sell at the close of thefourth trading day after opening the position. I realize this may seem odd.But of all the exit rules I tried, this one gave me the best results. In the 1.5year test period I was using (March 2001 to September 2002), the four-dayrule worked remarkably well. (That doesn’t mean it may not need adjusting at some point).If the market is downtrending, rallies last only about a day. So youneed to get out at the close of the next trading day. These rallies arewell worth playing, because they are sharp and powerful. However, remember that with a rally comes declining volatility, and you’ll need toplay it using ITM call options, or simply buying stock or futures. TheOTM and ATM call options may disappoint. For larger accounts, theother way of playing this would be selling naked puts. A short put position would beneﬁt from both the rising market and the declining volatility, a double bonus.If the market is downtrending, and you’ve gone long, the market needsto start going your way soon. If the market is down the next day, any timeafter the ﬁrst hour of trading, you should exit the long trade immediately.Not only that, but if your brief long trade interrupted a short position, youshould resume the short position immediately.Finally, I found that while long signals take precedence over beingshort, short signals should be ignored while you are long.
Everything Is RelativeMany VIX watchers pay attention to absolute levels. For instance, theymay say that the VIX at 22 percent or less indicates it’s time to goshort, and the VIX at 50 percent or higher signals a time to go long.Instead, I prefer to pay attention to patterns, and to the current VIXlevel in relation to recent levels. While the VIX has peaked in the 50sthree times in the past six years, there is nothing that says the VIXcouldn’t spike higher next time—perhaps even as high as it did in October 1987 (120 percent). Or perhaps intermediate-term bottoms will besignaled by the VIX only going into the 40s for the next few years. Younever know.
ccc_yates08_161-184.qxd 6/4/03 1:36 PM Page 176
176
ENCORE
The Bigger PictureLet’s step back and take a look at the VIX over a longer time frame. Referto Figures 8.15 and 8.16. There are some important observations to bemade here. In the past six years there have been six signiﬁcant VIX peaks,all corresponding to short-term market bottoms. Three of those times, theVIX poked above 40 for just one day, and that was the bottom day for themarket. The other three times, the VIX went above 40 and stayed above 40for many days. Then it spiked into the upper 50s one day, and that markedthe culmination of the market’s sell-off (note that the late 2001 spike hadseveral days in the 40s, even though you can’t see it in this weekly chart).Credit goes to Jim Graham on our staff for this study, the results of whichwere published July 12, 2002, in our company’s regular e-mail broadcastand are now posted on our web site.It is appropriate to pay attention to these patterns, and to assume thatthey may repeat. For instance, if I saw the VIX stay in the 40s for manydays, then move swiftly higher, and one day open up a gap to nearly 60 percent, I would go long with an extra large trade. Why? Because every timewe’ve seen that pattern in the past several years, it signaled a grand bottom. (A “grand bottom” is what I like to call an intermediate-term bottom.)I would use an extra large position in this case, because I would expect anextra high probability of success.Of course, a trader must be careful. Minimum and maximum levels exhibited in the past might not hold in the future. While the VIX is mean reverting, there is no law that says the VIX could not penetrate to some newhigh or low level never seen before. So the trader needs to be careful notto assume that the VIX is bound by some kind of ﬂoor and ceiling levels.Coming off a grand bottom, it is important to hold your longposition until the market has advanced at least 12 percent. The lastthree grand bottoms have seen the market advance very quickly at leastthat much:April 4, 2001September 21, 2001July 24, 2002
15%13%17%
Any short signal that the VIX may give during the ﬁrst few days following a grand bottom should be ignored, as the rally following a grand bottom is very powerful and must be allowed time to play out.
What Instruments to Trade?VIX timing signals may be traded using options, index futures, trust shares(such as the Standard & Poor’s Depositary Receipts, or SPY “spyders”),
FIGURE 8.15 Market Fluctuation over Six Years
ccc_yates08_161-184.qxd 6/4/03 1:36 PM Page 177
177
FIGURE 8.16 VIX Fluctuation over Six Years
ccc_yates08_161-184.qxd 6/4/03 1:36 PM Page 178
178
ccc_yates08_161-184.qxd 6/4/03 1:36 PM Page 179
Why a VIX Spike Stops a Market Sell-Off
179
or shares of individual stocks. When using options, special care must betaken to counter the effects of time decay and volatility changes. To goshort, purchasing puts works well when the market goes down quickly,because the accompanying increase in volatility pumps up their value andtime decay does not work against you very much. However, as we haveseen, a short position sometimes needs to be held for longer than just afew days. In this situation, buying ITM puts with very little time value isan effective approach.However, when going long, buying calls can be a problem because, asthe market climbs, the accompanying volatility decrease will work againstyour calls. One way to counter this is to buy ITM calls with very little timevalue. Well-capitalized investors may consider selling naked puts instead(note that high margin requirements are usually associated with sellingnaked index options). Nevertheless, shorting puts would be the ideal approach, because it beneﬁts from both the expected price movement and thedrop in volatility. Finally, one could perhaps sell puts and buy calls, constructing a synthetic. However, it’s not clear that using a synthetic wouldhave any advantage over simply buying futures or shares of the SPY.
SummaryVIX reversal trading is attractive for its high success rate—shown bymy studies to be 75 percent+ and by Connors and Che to be 65 percent+.It also has a high $win/$loss ratio. That is, the magnitude of the average gain is greater than the magnitude of the average loss. And, unlikeother timing methods that may work for a while and then stop working,VIX reversal trading should always work. Of course, no trading approach is easy. You’ll still have positions go against you. But the VIXsure does an excellent job of calling the bottoms, especially the bigones—to the day.
WHY A VIX SPIKE STOPS A MARKET SELL-OFFSince a VIX spike (often with a gap opening) always seems to happen atthe culmination of a sell-off, I have often wondered if there could be acause-and-effect relationship. That is, rather than just signaling the bottom, could the extremely expensive options actually have a braking effecton the market’s fall?After giving it some thought, I believe that expensive options might actually play a role in stopping a sell-off. Let me explain my hypothesis.
ccc_yates08_161-184.qxd 6/4/03 1:36 PM Page 180
180
ENCORE
As the downward market snowballs, many who were loosely holdingtheir stocks give way and add to the selling. Many portfolio managers,needing to lighten up but preferring not to sell their stocks, buy puts instead. As the market falls, demand for puts grows day by day. Market makers absorb this demand by taking on short put positions. As they do, theyopen short futures positions (in the S&P 500) to hedge. The selling of futures contracts translates into selling of shares through arbitrage.* Thus,the portfolio managers’ put buying transfers selling pressure to the marketindirectly, contributing to the market’s fall. As put buying approaches acrescendo, the market makers begin to approach a saturation point interms of their positions, and start moving put prices up in jumps. (By theway, the call prices have to go up as well because of put/call parity, butcalls are not relevant in this scenario.)At some point, portfolio managers decide they can no longer pay theprices being asked for puts, or that they have bought enough puts. Theymay also feel that the market has fallen so far that it shouldn’t fall much further, and decide to self-insure any remaining risk, at least until the markethas recovered somewhat. Thus they take themselves off the teeter-totter, ifyou will.At this point we need to step back and get a glimpse of the grand picture. There has been massive selling. Some of this selling has been directselling—people selling stocks, and institutions selling stocks or stock index futures (e.g., the S&P 500 futures) to hedge. But another segment hasbeen selling indirectly through buying puts. When this segment stops buying puts, as I imagine happens when the price of puts gets too high forthem, that’s when the teeter-totter swings the other direction. Bargainhunters and the background buyers who are always there begin to gain theupper hand, and the market begins to move up.
*Note that buying and selling in S&P 500 futures transfers into buying and sellingof stocks by means of program trading. Most large investment ﬁrms have arbitragedepartments assigned to watch the S&P 500 futures and to trade the futuresagainst actual stocks. When the futures are depressed to a certain point from selling, arbitrageurs will buy the futures and simultaneously sell hundreds of stocks ina “program trade,” thus lifting the futures and pushing down stocks (effectivelyending the opportunity). Likewise, when the futures are inﬂated to a certain pointfrom buying, arbitrageurs will sell the futures and simultaneously buy stocks, thuspushing down the futures and lifting stocks.Thus the buying and selling of the futures is effectively, although indirectly,the buying and selling of stocks. This transfer mechanism is very powerful andefﬁcient.
ccc_yates08_161-184.qxd 6/4/03 1:36 PM Page 181
Why a VIX Spike Stops a Market Sell-Off
181
Once the tide begins to ﬂow the other way, the momentum feeds on itself. As the market moves higher, market makers need to buy in some oftheir short futures positions because their short put positions are shrinking and no longer require as many futures contracts for hedging. This futures buying represents upward pressure on the market, sending it higher.At the same time, some portfolio managers, feeling relieved and perhapsoptimistic, for sure don’t buy any more puts, and may even feel the need toclose some of their put positions while they can still get something forthem. This put selling indirectly transfers buying pressure onto the market, again contributing to the rally. Meanwhile, many direct sellers, sensingthat the market may have hit bottom, turn around and become direct buyers. And up it goes.Thus the ﬂow of money into puts during a sell-off, and the consequentinﬂation of put prices, seems to act like an air bag for the market, ultimately stopping its crash and contributing to the market’s rebound.Again, I’m not certain this is what happens, but I believe it is likely. Ihave been discussing this hypothesis with key members of the investmentcommunity to get their feedback and see if they also believe this is whathappens. Any readers who have an opinion are welcome to send me an email as well. Figure 8.17 illustrates the whole process.
ccc_yates08_161-184.qxd 6/4/03 1:36 PM Page 182
182
ENCORE
Point ADirection: Market Is Falling, VIX Rising
RetailInstitutional (Portfolio Mgrs.)
Market Makers
Uncertain owners sell, accelerating drop.Some selling shares, some selling S&Pfutures; many, unwilling to sell shares,buy puts to protect holdings.Take other side—short put positions;balance by shorting S&P futures.
Point BDirection: Market Falls Further, VIX Jumps
RetailInstitutional (Portfolio Mgrs.)Market Makers
Uncertain owners still selling.More put buying.Less willing to take other side as shortput positions mount; increase prices atwhich they are willing to trade.
Point CDirection: Market Reaches Bottom, VIX Tops Out
RetailInstitutional (Portfolio Mgrs.)Market Makers
Most uncertain owners have already sold.Not willing to pay higher put prices,self-insure.Positions stabilize as put buying slows.Perhaps some professional options traderscome in, willing to sell high put premiums.
Point DDirection: Market Begins to Turn Up, VIX Dropping
RetailInstitutional (Portfolio Mgrs.)
Market Makers
Bargain hunters begin to gain upper hand.Bargain hunters—for sure, sense no needto buy puts.Begin selling back puts while they havesome value.Short put positions shrinking in value.Buying in short S&P futures positions tocover.
Point EDirection: Market Moves Higher, VIX Drops
RetailInstitutional (Portfolio Mgrs.)Market Makers
Buying accelerates out of fear of missingbargain prices.Continued buying.Continued buying to cover short S&P futures.
FIGURE 8.17 Anatomy of a Selling Climax
ccc_yates08_161-184.qxd 6/4/03 1:36 PM Page 183
Why a VIX Spike Stops a Market Sell-Off
183
The VIXThe VIX, or volatility index, measures implied volatility in index optionsfrom real-time OEX index option bid/asked prices. Produced by the CBOEsince 1993, this index is calculated by taking a weighted average of theimplied volatilities from eight OEX calls and puts. The options selectedare the closest to the money and the closest to having 30-day duration.Using an appropriate weighting scheme, the VIX represents the impliedvolatility of a hypothetical 30-day, ATM option. That is, after multiplyingby a constant.When the CBOE developed the VIX, they used the consulting servicesof Professor Robert E. Whaley of the Fuqua School of Business at Duke University. Noting that all options, except options in their ﬁnal week, havemore calendar days than trading days remaining, Professor Whaley reasoned, in his paper “The Investor Fear Gauge,” published February 4,2000, that since stock return volatility over the weekend is approximatelythe same as it is for other trading days, the implied volatility measured using standard options pricing models needs to be multiplied by the squareroot of the number of calendar days divided by the square root of thenumber of trading days.For an option with exactly one calendar week remaining, this wouldbe the square root of 7 divided by the square root of 5, or 1.18. Optionsof other durations would presumably have different adjustment factors.But since the VIX represents a hypothetical 30-day option, one would presume that, with 22 trading days within the usual 30 calendar days, the adjustment factor would be the square root of 30 divided by the square rootof 22, or 1.167. By comparing some IV numbers from the OEX matrix atvarious snapshots in the past with the VIX at those times, I found this tobe roughly correct.Thus the VIX is 1.167 times higher than the implied volatility of a hypothetical 30-day OEX option. One could question the need for this adjustment, as it tends to isolate the VIX, making it incomparable to othervolatility numbers. It is also useless as a number to be plugged into astandard options pricing model. That is, unless you have some kind oftrading-days-based options pricing model—something I’ve never seen norheard of anyone using.Interest rates and costs of carry, important elements in any optionspricing model, continue through the weekend. I believe that’s why standard options pricing models are calendar-day based. The VIX would haveto be adjusted back down before it could be plugged into a standard, calendar-day-based options model.
ccc_yates08_161-184.qxd 6/4/03 1:36 PM Page 184
184
ENCORE
Thankfully, the constant adjustment factor does nothing to hurt theVIX’s usefulness in comparison with itself. That is, viewing a historicalchart of the VIX is good for gaining a general indication of volatility levelsin the past.Finally, note that the VIX is not the only indicator of its kind. There isalso a VXN to reﬂect implied volatilities in the NDX (Nasdaq 100) options,and a QQV to reﬂect implied volatilities in the QQQ (Nasdaq 100 Holders)options. There may be others.
ccc_yates_start_185-194.qxd 6/4/03 1:36 PM Page 185
Starting the Business(on a Shoestring)
A
bout the time that I was writing my ﬁrst options software on myﬁrst PC, I was also increasingly discontented with my position withIBM. I enjoyed most of my years at IBM. And while my education atPurdue laid a foundation, it was at IBM that I learned what engineering isall about. I worked with a lot of good people and helped to develop someexciting products. However, the division I was in had run into a stagnantperiod and was not pursuing anything new and exciting. The company execs were having trouble ﬁguring out what business opportunities to pursue next. When you’re an animal the size of a dinosaur, you look for bigmeals and in the process pass over many smaller meals. The problem is,many apparently small business opportunities grow into large opportunities over time—and it’s impossible to know ahead of time which ones willturn out big. So, in my humble opinion, you have to invest in several areasat a time. I believe IBM could have been, and probably should have been,what Cisco, Oracle, and Sun became.Anyway, I was assigned to a job coordinating test procedures andpushing paper. I don’t think I did any development work—the work I trulylove—for almost a year. That’s when I started exploring job opportunitiesoutside the company and landed a job with Tandem Computers—with a 26percent pay increase!Tandem was a new technology company, and its high-ﬂying stock wasone of the darlings on the Nasdaq. Based in Cupertino, California, theirproduct was fault-tolerant, expandable minicomputers for business applications that needed to be up and running all the time. They hired me tohelp ﬁnish the development of a new smart terminal that worked with185
ccc_yates_start_185-194.qxd 6/4/03 1:36 PM Page 186
186
STARTING THE BUSINESS (ON A SHOESTRING)
their system. The Tandem work environment, with ﬂexible hours and theengineers coming to work in shorts and sandals, was radically differentthan I was used to. But it didn’t take me long to adapt! And I’ll never forgetthe company party (called a “beer bash”) that started every Friday at about4:00 P.M.!During those early days at Tandem, I continued developing my personal trading software after hours. I worked all day at Tandem and thenworked on my hobby until midnight. Once the software was ready, I put itto work trading spreads. That’s when it occurred to me to convert my software into a general purpose options analysis program and see if I couldsell a few copies to individual traders.So I spent a few months preparing the software and named it OptionVue at the suggestion of a friend. Actually, there were two editions atﬁrst—OptionVue A, geared for covered writing or single option positions,and OptionVue B, mainly geared for spreads. I prepared separate versionsof each program for the IBM PC and the Tandy TRS-80 models II and III. Ipriced them at $129 each.Then I hired an ad agency to help me prepare print ads and press releases. I thought of a business name (Star Value Software) and had a logodesigned. I also spent a lot of time developing literature and cover lettersfor various target audiences. I was constantly improving upon these.These were new business activities to me, but I learned fast and enjoyedthese tasks very much.In March 1983, I suddenly found myself out of a job. Tandem was trimming its work force and my number came up. I think they were happy withmy work, but the moonlighting probably bothered them. Plus my endeavors had expanded to the point where they occupied some of my thoughtsduring work hours. I also think my direct supervisor secretly had my welfare in mind when he set me free to pursue what he could see was myheart’s desire, although he could not come right out and say so. Being ﬁredcame as a real shock. But then, some pain always goes with being pushedout of the nest, right?Yet something strange and wonderful happened to me then. It was theﬁrst time I had ever faced a situation in my career where I was free to pursue my heart’s desire, yet the transition was anything but safe. If I was going to pursue this new business idea full-time, I was going to have to trustthe Lord for income. My wife and I were just starting out and we did nothave a nest egg. All we had was our home equity to borrow against, plus acouple of credit cards we could draw upon (reluctantly), and a motorcycleI could sell (very reluctantly). The business was only selling about 10copies of the software per month at that point, and that level of income didnot even cover the business expenses.Yet, with my wife’s encouragement, the decision was made almost im-
ccc_yates_start_185-194.qxd 6/4/03 1:36 PM Page 187
Starting the Business (on a Shoestring)
187
mediately to pursue the new