Using VIX to Predict Market Direction

The Volatility Index, also known as the VIX or the Fear Index, is a tool often remarked by investors and traders. It is a measure of implied volatility, as a per cent, and is used by many to determine where the market may be headed in the next month. A high VIX, above 30, suggests that market volatility is occurring and the market may be headed downwards. A low VIX suggests the market will remain calm and potentially be positive for the next month.

However, I have found that the VIX is a very reactionary index. Having traded the VIX options many times, one will recognize that the VIX makes significant moves only when the market has a large move in one day. A 200-point drop in the Dow may move the VIX up 2 or 3 points. Many would say that this rising VIX suggests more volatility ahead, but this is not always true.

Today, the Dow opened 110 points lower, with the VIX reacting, peaking at 27.32 up 3.19 points. As the day progressed, the Dow pared losses and flirted with positive territory, thus the VIX sank to back 24 and change. As you can see, it's not a very good tool to measure volatility if it's a reactionary device, but this is where the VIX options come in to play.

Using the VIX options to predict the market's next move is something I have been using ever since I noticed its strange behaviour and pricing back when I worked at the brokerage. It's good for those that have trouble with technical analysis or get caught up in emotional trading. Deep in-the-money options often paint a nice picture of the market's next move. Here's how it works.

First, we simply find the value of the VIX, ignoring its level and its "meaning." Then, we use the front-month options. If the VIX options expire in a few days, check the following month contracts. Find the deep in-the-money options and you will notice that either the calls or the puts will be under priced. That is, it will be missing intrinsic value. That missing intrinsic value will eventually be filled by a move in the VIX. This move can then be interpreted as a reactionary move against the market. Make sense? Here is an example using today's options level.

The VIX is currently at 24.19. So, let's check the August18 calls and puts. If the VIX were an actual security, we would know that the 20 call should be worth at least 4.19 and the 30 put should be worth at least 5.81, but the VIX does not trade like that. In fact, the 30 put is only worth about 5.30, missing intrinsic value of 0.51. This will mean that the VIX may move up 0.51 to correct this option mispricing. A move up in the VIX indicates a short-term down ward move in the stock market.

This is not a fool-proof method, but has proven more often than not to be accurate. Today is July 30, and the Dow is 10,421 as I write this. I am making a bold prediction using this technique that we will see it be worth less in the next few days.

Hayward Stepping Down... And Not a Moment Too Soon

Tony Hayward's career as BP CEO was doomed milliseconds after the oil spill destroyed the Gulf of Mexico, and if he did not step down, somebody would have ousted him from his perch. In the reality of business, and even sports and parenthood, the authority figure takes all the praise or the blame when a company succeeds or fails respectively, sometimes a little unfair to the thousands of employees who ultimately shape the ship.

The job of the CEO is to implement major rules and decisions that will lead to success, and as a result, many believe the specifics that led to explosion on Deepwater Horizon were not Hayward's fault. After all, he works all the way in Great Britain and the employees on the drill should have reported any problems to head office.

But these people trying to make a case that Hayward is merely a scapegoat are forgetting that BP's reputation as a safe and reliable oil company has not exactly been a long-standing one. Heck, you could argue it's been non-existent. Here are some facts and figures against its safety record:

- In two previous oil disasters, 30 BP workers were killed and more than 200 seriously injured.
- In the last three years, BP accounts for 97 per cent of violations in Ohio and Texas handed out by the Occupational Safety and Health Administration (OSHA).
- In the last five years, BP has had 760 "egregious, willful citations", according to the OSHA. The combined "egregious, willful citations" of all other oil companies is 1.
- The largest fine from the OSHA was to BP for not correcting problems at a rebuilt Texas plant. The fine was $87 million.

Again, as I said, it's unfair to blame the CEO for a few violations, but considering the number of safety violations BP has, it's tough to not point fingers at Hayward. When he took over as CEO, Hayward even said he would make BP a safe and reliable oil company. Well, I'm no teacher, but I'd give him an F.

The removal of Hayward has been viewed positively by shareholders today. If somebody really wants to put their mark on BP, it should be somebody who will stand for real change. Whatever is left of BP's reputation will be restored once a new CEO steps in, but only if real and immediate change occurs.

Weekly Options Expand to Stocks

Trading equity options on a monthly basis is a thing of the past, now that the CBOE has introduced weekly options to a small group of securities. As of July 5, 2010, weekly options were expanded from indexes to stocks and ETFs, including Apple, Google, Ford, and the Direxionshares Financials 3X (see link).

These new products, which launched at the start of earnings seasons (most likely intentional), enables traders with shorter time horizons to speculate on large movements in securities while paying a discount on time value. Long straddles may finally become a mathematically profitable trade, since the discount on time value creates a smaller break-even range. It will also allow options writers to become more active and take on less time risk, and possibly earn more income through calendar spreads and other strategies.

Every Thursday, the weekly options are introduced and expire the Friday in the following week, providing six days of existence, and two days for roll outs if required.

The weekly options have been very popular. In only three weeks of inception, volume on the weekly options are above 50 per cent volume of the regular monthly contract with the same strike. In many instances, they are trading with more volume and have more open interest as well.

So what are some ways to make money? Here are two real-life examples using today's closing prices for a company with and without earnings.

Amazon [AMZN:NDQ] with earnings July 22 closed at 117.43 on July 21:

Expiration	Option type	Strike	Premium (bid x ask)
July 23	Call	120.00	2.68 x 2.75
August 21	Call	120.00	4.90 x 5.00
July 23	Put	115.00	2.63 x 2.75
August 21	Put	115.00	4.95 x 5.05

Apple [AAPL:NDQ] with no earnings closed at 254.24 on July 21:

Expiration	Option type	Strike	Premium (bid x ask)
July 23	Call	260.00	1.03 x 1.05
August 21	Call	260.00	7.30 x 7.50
July 23	Put	250.00	1.26 x 1.33
August 21	Put	250.00	7.65 x 7.80

In the tables above, we see that Amazon weeklies, which releases earnings tomorrow, carry a premium more than half the monthlies. Although they are high, the premiums are significantly reduced. The break-even for a long straddle is now 114.50 and lower or 125.50 and higher, an immediate move of about 6.8 per cent, instead of 8.6 per cent.

And the Apple options, which no longer carry a premium for an earnings move, still carry $1 in value. Why does this matter? Many new option writers do not understand that writing options are profitable 95 per cent of the time. As a result, they are hesitant on writing the monthly options for fear the security will make a large move. Most traders will sacrifice significant time value and write them in the final week, exposing themselves to less risk, a forgiving characteristic. Now, providing weekly options allows these traders to make money every week.

Calendar spreads can also become very profitable. Spreads are a good way to replace longing stocks, especially expensive ones like Google, Apple, and Amazon (which also pay no dividend). Go long a LEAP and write calls at that strike or above.

I did a calendar spread for Apple prior to earnings on the 260 calls and made money on the August call going up in value and on the July calls losing a chunk of premiums after earnings. If it had gone above 260.00, I would have simply rolled out the July 23's to the July 30's and capture an additional week of time value.

Earnings to Disappoint?

Monday is the official start of earnings seasons, which means Alcoa [AA:NYSE] is set to report. And leading up to today, the US markets shone, surging over 5 per cent. What a great way to kick off the third quarter. But the move last week is highly suspect.

Analysts have shrugged the rally as a technical bounce, short coverage, and long-only money entering the market. The economic fundamentals have changed little in the past week, so a real turn around in the market must be justified with positive earnings reports, which many don't expect to occur.

The last time earnings seasons hit, Alcoa reported unfavourable numbers, resulting in the stock to drop, along with the market. Historically, earnings seasons has done very little to support market moves, and have provided negative returns during the six weeks, occuring four times a year.

Expecting blow out numbers probably won't be in the cards. Just in the past two weeks, many other large firms have reported with dismal results. Adobe Systems [ADBE:NDQ] and Research in Motion [RIM:TSE][RIMM:NDQ] reported their own quarterly numbers for the spring and both stocks plummeted over the next few days. They may not be the "bell weather" that Alcoa has been designated, but they may be a sign of things to come.

Other big technology stocks are expected to post results in July, including Intel, Apple, and Google. All three stocks have performed differently year-to-date.

Many analysts believe that based on the stock market's move over the past few weeks, expectations have been lowered, but is this truly indicative of how traders really feel?

CNBC says that investors have started to shift focus towards growth in revenue, and not profitability. Cost cutting strategies helped them survive the recession, but now it is time to provide growth. Personally, I don't see many companies filling that expectation; there just hasn't been enough job growth for that.

On the other hand, I have been wrong plenty of times before, so we'll just have to see how this week unfolds. It will be a good one, especially with options expiry just a few days away.

Dealing with ECN Fees

Three times in the last few months, my friend asked me how much my broker (TD Waterhouse Discount Brokerage) charged me for ECN fees. Each time, I would tell him I do not pay ECN fees. He currently uses Questrade which is notorious for charging ECN fees above market fees. Just do a Google search for "Questrade ECN fees" and you will come across threads of angry and confused customers paying an extra $40 or more. Questrade's low commissions attracts customers, but they stay profitable by charging ECN fees, unlike many other large institutions that charge higher commissions ($19-29) to absorb the costs of ECN fees, as well as other potential fees.

Below is a table of some major North American exchanges and their ECN Fees. I've also included Questrade's ECN charges which I obtained directly from their website.

ECN Fee Structure for stocks $1.00 and Over; in dollars per share.
CDN Markets	Exchange	Questrade
Alpha (ATS)	0.00253	0.0037
Chi-X	0.0029	0.0037
Pure Trading	0.0025	0.0037
TSX	0.00341	0.0037
US Markets
BATS	0.0025	N/A
NASDAQ	0.0030	0.0030
NYSE	0.00302	0.0040
NYSE ARCA	0.00302	0.0040

¹TSX charges between $0.0033 to $0.0035 per share. The amount in the table is the median charge.
²NYSE and NYSE ARCA charge between $0.0029 to $0.0031 per share. The amount in the table is the median charge.
³Alpha (ATS) uses a three-tier system for Continuous Active fees. The value used in the table is the charge for equities between $1.00 and $5.00.

ECN fees only occur when you remove liquidity from the market. That is, when you buy at the ask or sell at the bid. You are essentially removing shares from the market that were for sale or purchase. But when you add liquidity (enters a buy below the ask or a sell above the bid) to the market, the exchanges do not charge you an ECN fee. In fact, if you provide liquidity, the exchange provides a rebate, but most retail investors will never see this return.

In Canada, the law requires brokerages to route equity orders to the exchange with the best possible fill. Fortunately, most exchanges have fees that are very similar, but it is possible to hit an exchange that charges substantially higher fees not included in the list above. There are over a dozen US stock exchanges you might not have heard of, such as the Miami Stock Exchange and National (Cincinnati) Stock Exchange, and hitting these exchanges can happen quite frequently. The National Stock Exchange accounts for about 20 per cent of the transactions for NASDAQ-listed stocks.

For traders, simply putting in a limit order a penny below the ask or above the bid will remove that ECN fee, but this is not practical for low-volume equities. Low-priced equities will also generate larger ECN fees since many will hold thousands of shares. A third of a cent adds up when you hold five- or six-digit shares. So before you start trading, account for all charges and commissions. ECN fees can add up over the long run.

Satireland: Book 1, Chapter 2

Social Similes: A Parody of Our World - Set 6 Volume 4
Clash of the Britains - 2010 1H

"Attention passengers, this is your captain speaking. Due to the lingering volcanic ash over Heathrow, we will be making a stop in Athens until we have been granted permission to land in London. Thank you."

The airport was crammed with thousands of passengers waiting for the volcanic ash to disappear. Lord Hayward and Robert found out that it could take days before the skies were clear enough for pilots to fly safely. And the crowd was becoming uncivilized and hostile. The two decided they would find refuge in a hotel with what little cash they had on hand and clean themselves up.

Minutes passed by and no taxis showed up. The two were later informed taxis were unavailable. They were in disbelief and decided to hitchhike down Beaverdam Road unaware that east of the airport was mainly farmland.

Nearly two hours later, exhaustion and dehydration mounted, unknowingly, they continued along the path to no where. Finally, a vehicle stopped to pick them up. To their amazement, it was Tiger Woods. He had just finished a booty call with a Greek lover.

Lord Hayward and Robert were supposed to be dropped off at the Holiday Inn on East Broad Street, but Woods crashed into a tree. The two Brits came out unscathed, but Tiger Woods was not as fortunate. After calling for emergency workers, they walked to the downtown.

After reaching the heart of the city, they saw terrifying scenes. It turned out the nation was currently on a general strike, as thousands of union workers were demonstrating against the government and it was getting ugly. Taxi drivers were included, the reason why they were unable to find a taxi at the airport.

The strikers were angry, frustrated, and hostile. They were planning a violent assault on the police and military. Lord Hayward and Robert did not want any part of this, but were unable to reverse course; they were stuck in the middle of the unrest.

A loud, booming voice announced, "Release the Kraken!" and chaos ensued. Hordes of evil minions from the depths of Hades blanketed the skies. Mortals ran in fear as Perseus appeared and fought the Kraken. It was a short-lived battle that would be deemed lacking if it had appeared in a 2010 movie remake of a classic film.


Unlike many, Lord Hayward and Robert escaped uninjured and continued to the hotel.

They would finally arrive at the Holiday Inn ready to relax with a cup of tea or whatever the British do.
"Hi, my colleague and I would like to book a hotel room for a few nights," said Lord Hayward. We do not have any Euros, but do have British Pounds."
"BRITISH POUNDS??!" hollered the receptionist in joy. "Why, due to the falling Euro, one British Pound is worth nearly 700 Euros. Would you like our royalty suite?"
"Why of course."

Finally, Lord Hayward and Robert reached the end of the journey. They had persevered through peculiar events and survived harsh conditions of Africa and Greece. Sadly, there were some casualties along the way, including a toy Yoda.

Satireland: Book 1, Chapter 1

Social Similes: A Parody of Our World - Set 6 Volume 3
Clash of the Britains - 2010 1H

Once upon a time, a soldier named Robert Green was sent into military action to the land of the lions. But his poor performance resulted in harsh criticism and he was ostracized by his platoon. For you see, Robert tried to take a bullet for his squad, but was ill-prepared. The bullet penetrated the last line of defense and their enemies, the Americans, forced the British to surrender two strategic points in the war.

Green's disastrous heroic attempts forced the British to make huge changes to their squad. Back home, he was labelled a national disgrace, and nobody wanted him, not even his parents. But one man flew all the way to Africa to offer him a glimmer of hope.

"Hello, Robert Green?" He asked.
"Yes." Robert replied.
"My name is Lord Tony Hayward," the mysterious man explained. "I am the king of oil and your guardian angel. Your recent action has made you a disgrace back home, but I am here to offer you some support. Let me show you what the world would be like if you were never born."

The two stepped into Lord Hayward's automobile and headed back to the airport. But they would soon undertake a journey full of anguish and adversity. Courage, strength, and determination would ultimately prevail as they continued their trip home. This is the story of Lord Hayward and young Robert and their journey of hell.

Within the first hour, the vehicle showed signs of problems, but went undetected by the two passengers. Shortly after leaving the military base, the vehicle's brakes malfunctioned, sending Lord Hayward's vehicle and his toy Yoda on a high-speed cruise. Unable to take control of his vehicle, the Lord made a last ditch effort to stop the runaway car and made a sharp right turn into a fence barricading drivers from a 100-foot cliff, but it was no use. The vehicle, and his toy Yoda, flew over the cliff and landed in a beautiful oasis. The two passengers were knocked unconscious for a short period of time.

When Lord Hayward and young Robert woke up, they found themselves in a beautiful lake. The trees towered even the tallest giraffe, and rays of light broke the canopy of the cluster of trees that provided them shade. Song birds sang in happiness and fish were jumping out of the lakes, like a Disney cartoon ready to break into a musical. The animals around them took notice of the two humans, but did not find them threatening and continued drinking from the water.

Just then, the under carriage of the vehicle exploded, causing liquids and oil to leak into the oasis. Lord Hayward tried to stop it by covering the leak with his hat, but the pressure was too strong. Robert tried to cut open a second hole to lower the pressure, but his tools were not strong enough to penetrate the medal. All the animals starting getting sick and were covered in this oil. The area, which was the only oasis for nearly 450 miles, was destroyed.

The two decided that their only hope of survival was to get to the shore. Tired as they were, they climbed the cliff to get help. But before they reached the bottom of the cliff, they stumbled upon a talking green troll, an anthropomorphized being inhabited at the lake.

"Get out of my swamp! Argh!" the green troll requested angrily. He had not yet seen the destruction of the oasis, but soon realized it. "What... happ - MY CRYSTALS!" It turned out the green troll had four cup-like glass crystals which he collected from the Americans. The crystals were beautiful in design, but were harmful to the humans due to extreme levels of cadmium.

As the troll went to save his crystals, the Lord and Robert attempted to scurry away, but the troll heard them make a run for it, and chased them down, hoping to punish them for what they did. The troll's friends, which included a talking donkey, a giant gingerbread man, and a cat in boots, appeared out of no where and battled the two. It would end when Lord Hayward tripped the giant gingerbread man and crushed their foes.

As they escaped and climbed the cliff, they were attacked by a swarm of bees, or at least it sounded like it. They did not see a single insect, but heard the annoying buzz-like sound faintly in the distance. Squinting to get a better look, they realized it was a caravan of South Africans, not bees, playing a local instrument known as the vuvuzela. The drivers offered the two British men a safe ride to the airport, but it was only a short intermission from continued adversity.

Next chapter (to be posted July 4)

The Death Cross Will Happen

"The charts don't lie" is a common phrase that exists amongst traders. It is an accurate, but not guarantee, barometer of investor sentiment and long-term concerns or beliefs. The charts on the S&P 500 and the Dow Jones have continued to show bearish signals since the start of May.

In the middle of May, I noted that the 200-day moving average was breached by all the major North American exchanges (see link) and discussed in a technical analysis blog about the functions of the moving average (see link). Since that date, the Dow Jones has fallen about 1,000 points. And now, we have two big signals the market may fall a little more.

Yesterday, the S&P 500, the Dow Jones, and the NASDAQ all hit 2010 lows, with more lows reached today. The S&P 500 had a key support level at 1,040 which was breached to the downside, indicating further drops to follow. And today, the market is now watching an upcoming death cross.

The death cross, which occurs when the 50-day moving average drops below the 200-day moving average, is a sign that stocks or asset classes will fall further, hence the name. Although the event has not yet occurred, it is fair to say this will happen in the next few days. Mathematically, the Dow Jones must move up 2,000 points in the next day to reverse the falling 50-day average. If you check the charts, the 2-week upward run in June of 800 points did not deflect the 50-day average.



I am anticipating the death cross to occur next week. We may see traders or firms try to delay the event by pushing the market up, even if tomorrow's job reports is positive, but the negative sentiment will take over.

It would be a wise decision to purchase some insurance or write in-the-money calls until a real turn around in the fundamentals is evident.