Volatility Effects

A reader commented and asked: “It seems there are indeed systems in Collective2 that make money on a walk-forward basis even considering trading frictions. VT26 is one of them (for autotrading at Collective2, you can assume on average $8.50 per contract per round turn). How does this stand versus your skeptical approach?” The author of VT26 describes it briefly as a 100% automated volatility breakout system with priorities on steady profits and small drawdowns. He provides further description of the strategy in “Report on Systematic Portfolio VT26.” Using trade-by-trade data for VT26 for the period 4/9/08 through 3/8/10 (2,279 closed trades over 23 months across ten futures markets), we find that: Keep Reading

Does positive feedback trading, indicated by an adjusted measure of return autocorrelation, enhance momentum profitability? In the February 2010 version of their paper entitled “Positive Feedback Trading Activities and Momentum Profits” [apparently removed from SSRN, thus casting doubt on its credibility], Thomas Chiang, Xiaoli Liang and Jian Shi examine the relationship between positive feedback trading and profitability of momentum strategies. The momentum parameters for their investigation are a six-month ranking interval followed by a six-month holding interval. Measurement of positive feedback trading is for a six-month window coinciding with the momentum ranking interval. Using daily stock return data for a broad sample of U.S. stocks spanning 1985-2005, they conclude that: Keep Reading

How much of the variation in stock returns flows from actual (realized or backward-looking) and implied (forward-looking) market volatilities? In the January 2010 version of his paper entitled “Option Implied Volatility Factors and the Cross-Section of Market Risk Premia”, Junye Li investigates the effectiveness of a three-factor model of stock returns based on market return (beta), diffusion volatility (moderate and persistent component) and jump volatility (large and mean-reverting component). The author also examines how the value premium and size effect relate to the two volatility factors and how relying only on realized market volatility affects results. Using weekly (Wednesday) data for the S&P 500 Index, S&P 500 Index options (filtering out options with extremely long/short durations, extreme moneyness and low activity) and the S&P 500 Volatility Index (VIX) spanning January 1997 through September 2008 (608 weeks), he concludes that: Keep Reading

A reader suggested: “You might test the Bollinger Band- Keltner Channel breakout detection model on the euro. Equity indexes generally have performed anti-trend (reversion to the mean) whereas currencies have trended.” Keep Reading

A reader, citing a technical indicator recommended in Mastering the Trade by John Carter, inquired about the usefulness of watching for times when certain Bollinger Bands (upper and lower bounds two standard deviations from a 20-day simple moving average) converge within a certain Keltner Channel (upper and lower bounds 1.5 times the 20-day average range from a 20-day average typical price). Breakouts from this condition are supposedly reliable for both indexes and individual securities, meaning that price continues in same direction for a while without material reversal, because the condition represents true “consolidation.” There is no specification for trend duration after these “reliable” breakouts. Using daily high, low and unadjusted closing prices for S&P Depository Receipts (SPY) for band/channel calculations, and adjusted closing prices for return calculations, over the period 1/29/93 through 1/8/10 (nearly 17 years), we find that: Keep Reading

Conventional wisdom holds that a low market valuation ratio and a high market volatility both relate positively to future market return. Do valuation ratio and volatility therefore relate negatively to each other with some consistency? If not, why not? In their November 2009 paper entitled “What Ties Return Volatilities to Price Valuations and Fundamentals?”, Alexander David and Pietro Veronesi investigate the relationships between stock and bond valuations and their volatilities in the context of varying investor beliefs about future economic growth and inflation. Using S&P 500 operating earnings from Standard & Poor’s, daily closes of the S&P 500 Index, daily bond yield/return data and monthly values of the Consumer Price Index over the period 1958 through 2008 (51 years), they conclude that: Keep Reading

A reader asked: “Today (12/04/09), the Dec 27.5 VIX put options had a negative extrinsic value [option price – (strike value – VIX level)] of $-0.36 with bid-ask spread $0.50. Is there something about VIX that makes this situation not abnormal?” Keep Reading

Is there a way to optimize dynamically the degree of leverage for an investment? In his November 2009 paper entitled “On the Performance of Leveraged and Optimally Leveraged Investment Funds”, Guido Giese derives a general model for leveraged multi-asset investment strategies with daily re-balancing applicable to leveraged long and short Exchange-Traded Funds (ETF) and leveraged carry trades. Using daily data for the Dow Jones EURO STOXX 50 Index, the Dow Jones EURO STOXX 50 Volatility Index (VSTOXX) and the Euro OverNight Index Average (EONIA) rate from end of 1991 through May 2009, he concludes that: Keep Reading

A reader asked: “You have had multiple blog entries regarding the erosion of price in leveraged funds due to re-balancing costs. Why are there long periods during which this erosion appears not to occur? I have been short both Ultra S&P500 ProShares (SSO) and UltraShort S&P500 ProShares (SDS) since June 1, 2009 and am losing money. Thoughts?” Keep Reading

Does the Chicago Board Options Exchange Volatility Index (VIX) have separable components of rational and irrational risk? If so, is the irrational risk component of use to investors? In their October 2009 paper entitled “Risk Sentiment Index (RSI) and Market Anomalies”, Guy Kaplanski and Haim Levy introduce the Risk Sentiment Index (RSI) as a measure of the residual risk contained in VIX after accounting for the statistical and economic variables most predictive of future stock market volatility (such as previous month actual volatility and VIX). They also analyze factors which affect RSI and its relationships with day-of-the-week and month-of-the-year stock market anomalies. Using daily closes for VIX and the S&P 500 Index during 1990-2007 (4,538 days) and for the Volatility Index Japan (VXJ) and the Nikkei 225 Index during 1995-2007 (3,200 days), they conclude that: Keep Reading