Canadian VIX: TSX to have their own volatility index

I don't know if anyone noticed, but in my previous post discussing the TSX, I included a chart of VIX (S&P500 volatility index) versus S&P 500. VIX is one of the market indicators that I can't live without. However, as much as the Canadian and the American equity markets are correlated, they are still separate markets. So using the VIX vs. S&P500 on an analysis of the TSX is like borrowing salt from thy neighbour. But there's no more need for that soon as TSX is finally getting its own volatility index starting Monday (October 18)! This is to replace the MX Implied Volatility Index (MVX) from the Montreal Exchange, which I didn't have access to previously (aside from data published on their website). One question I have is that the TSX VIX will be based on TSX 60 index options activity according on their press release, but the TSX 60 index options isn't that active. So would the TSX VIX be as efficient as the S&P500 VIX? An opportunity with the introduction of TSX VIX on the Toronto Exchange is that I can now place bets on market volatility in my self-directed RRSP trading account. Which is arguably more predictable than the underlying index these days... In any case, this will be a vital market indicator for Canadian market traders. For more information on TSX VIX, see the product information page on Standard & Poor's. And a hat tip to Option Matters (Montreal Exchange's blog on options) for this news.

Posted 14 October 2010 in stocks.

A leading indicator to spot financial market Black Swan Events?

Black Swan Events or 4-sigma moves (e.g. 1987 Black Monday and 2008 crash) in the markets are by definition hard to predict. Hard, but not impossible. Experienced traders utilize prudent risk management to shield themselves from monstrous losses, and some can even profit immensely from them. However, for us average folks, is there some kind of simple warning signs that could give us a heads up to these sort of extraordinary moves? In this post, I will introduce a simple leading indicator that seems to do the job quite well. I will talk about what it is and why it seems to work. Of course, this is merely based on limited observations and is not to be construed as a vigorous analysis. The particular indicator I am referring to is the Google Investing Index (GII). Figure 1 below shows the GII vs. S&P 500 from 2004. The blue line is the GII, the red line is the S&P 500. What I have observed is that rapid (in a month's time) rise from a negative reading to +20% reading of GII correspond with a shift in sentiment in the market rather well. Referring to Figure 1 below, this condition occurred 4 times since 2004. I marked these 4 occurrences on the graph with green dots. As you can see, they correspond with the double top on S&P, first dive in the crash, the big one in October 2008, and then even confirming the 666 reversal in March 2009. It seems to be a leading indicator for down moves but lagging on upward reveral. Mostly noticeably though, is that the GII gave extreme readings, and in the direction of our condition (negative to positive jump), days before the big crash in October 2008.

[caption id="" align="aligncenter" width="580" caption="Google Investing Index vs. S&P 500 (green dots mark signals)"][Google Investing Index
vs. S&P 500]Google Investing Index vs. S&P 500[/caption] While this can be mere coincidence, here is why I think this index holds some truth. The GII measures the amount of search traffic for topics relating to investing in the U.S. And with Google dominating the online searching market (65% as of October 2009 according to comScore), we can assume GII to measure what the general public is interested in. Now, as we probably know, market extremes are driven by irrational emotions. There's an old saying that goes like this, on market highs, when even the taxi driver is giving you stock advice, it's time to get out of the market. When all the people have invested already, who's left to buy and drive the price even higher? This is ultimately a supply and demand effect. While we can't count heads in the market, we can estimate market sentiment. The GII is just one more way of doing that. And it does so by giving us a reading of the market sentiment according to the general public. You know, the last ones in the party to pickup the mess the pros have have left behind. That is exactly what sets the GII apart from the plethora of existing market sentiment indicators. It is a market sentiment indicator on mass psychology, but a crude one at that. Scoring 4 out of 4 positives is good, but the small sample size render this a mere observation of interest. I do not recommend trading on this indicator. However, it does seem promising to serve as an additonal input to an analytical system... In summary, here is the condition of this GIS (for Google Investing index for market Sentiment) indicator.

  • the condition is true for a turn in the market when GII jumps from a negative to +20% or more within a month.

Lastly, notice that the GII is still low at the moment while many are calling the top is imminent, or even that it has happened at 1120 in recent weeks. Thus, according to GIS indicator, this market rally is still intact.

How to use FX futures to narrow down which forex pair to trade

A problem I have is that once a currency pair shows a viable trading setup, other related pairs often show the same setup too. A reason for this phenomenon is that markets don't operate in a vacuum. When markets really move, everything move together. So the highly correlated markets can scream for entry at the same time. The real question though, is which one should I put my chips in? There are limitless methods on how you can approach this. The one I'll talk about in this post is a simple method of comparing your candidates using the currency futures. Why use the futures? Because they provide a standardized platform, which is essential when comparing things. As a bonus, there is a US dollar index futures to help with analysis of the dollar. Not a trivial process on its own. I will explain my method by way of an example. This morning, I was considering to go long in AUD/JPY, CAD/JPY, AUD/USD, or short USD/CAD according to signals from my FTC setup. Sure, I could have just choose which one to trade based on the RSI rating or some other indicator. But I don't put much faith in indicators for various reasons. So a method I typical use is to just go through the charts to manulally identify which has better reward/risk or better support/resistance. As you can imagine, this is very time consuming. In practice, I only compare AUD/JPY vs. CAD/JPY and AUD/USD vs. USD/CAD, and then compare the winners of those two matches. Like in a tournament. Not that much of a hassle but the issue with this approach is that I'm adding another layer of uncertainty with all these unscientific comparisons. That could have a significant negative impact on my trading. In a good trading strategy, every step taken should be to improve your probability of success or the reward/risk ratio. As such, it's better to keep my process simple. This is where the currency futures indices is of value. They provide a big picture perspective and serve as a standardized data for comparison. Using my example, I needed to choose between shorting US dollar or Japanese yen (I repeated the process for choosing AUD or CAD). Figure 1 below shows the 4-hour chart of both currencies for the past 10 days. It's evident from the chart that the US dollar is in a range and the Japanese yen (actually it's JPY/USD) is moving up. 1 point goes to US dollar trade. Next, I identify the strength of the support/resistance to estimate in the case that the trade goes against me, which would have better cushioning. It's a crude form of risk estimation. From the figure below, see that the dollar has a clear resistance just below 76 and it is currently stretched away from the cyan-coloured moving average. Whereas the yen is near a recent top with no prior occurence and it has been sitting above the moving average for a while. Another point for dollar short. USD 2 : JPY 0. Consequently, I went long AUD/USD this morning instead of AUD/JPY. This is by no means a vigorous methodology. I'm not saying that shorting US dollar is a good idea from this simplistic comparative process. It's just that my setup tells me to go long AUD/USD or AUD/JPY, this is just a quick and easy way to help me decide which trade to take. Nothing more. As an aside, some people may prefer to use currency ETF, UUP and FXY, instead. But I don't like to use ETF as a data source as the price is noisier because they are affected by other factors.

[caption id="" align="aligncenter" width="504" caption="US dollar and Japanese yen futures indices"]US dollar and Japanese yen futures
indices[/caption]

Using Option Pain (Max Pain) to estimate stock price

While the market is sorting things out today, I'd like to document a simple stock price predictor based on put/call activity called Option Pain or Max Pain.

It is widely believed that professional traders favour writing options. Since trading options is a zero-sum game, it is in their best interest if a majority of options expire worthless on expiration day.

By observing the open interest of a stock at each strike price, we can see at what price the Option Pain would occur. Of course, this is just another tool for the trader to use, so do your own due diligence as usual when trading.

[caption id="attachment_500" align="aligncenter" width="500" caption="SLW Nov08 Max Pain"][Nov '08 SLW Option Pain][][/caption]

Using this chart from Option Pain, we can see that the minimum option total value of November SLW is at \$5. So our max pain price is at \$5 for November's SLW. That is to say, if SLW settles at \$5, then the most call option would expire worthless and most of the put option would expire worthless. Such that the option sellers (the pros) can pocket your money.

Another way to use this information is to find the best Max Pain to Current Price ratio among a list of stocks. For example, SLW closed at \$2.59 yesterday. Its max pain is \$5 from the chart above. That is almost a double. Note, however, that we haven't figured out the probability of SLW reaching \$5. This would be something for me to look into.

In comparison, GOOG's max pain for November is at \$360. Its previous closing price is 329.49. Based on these numbers, SLW is a better buy than GOOG for now.

[Nov '08 SLW Option Pain]: http://traderpau.files.wordpress.com/2008/10/slw-optionpain.jpg

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