February 10, 2004

Cracks of Doom

The Insider is a work in progress. And so I've found myself shifting to a longer market review each day...so we can focus on the first things first, money, and then incorporate the other things as they come in. So I'll try each day to review the big themes (through the prism of my five indicators), and then ad other insights as they seem pertinent. Let me know if this style suits you, or if it doesn't. Yesterday I mentioned that I keep an eye on five indicators to tell me where the market’s at and where investors are at. The five were: the Volatility Index (VIX), the S&P 100 (OEX), the Commitment of Traders Report, the put/call ratio, and my own private BEDspread. Some noteworthy developments in a few of those areas yesterday. First, the Chicago Board Options Exchange said volume rose 54% on a year over year basis. The exchange reported volume of 34 million contracts in January versus 22.1 million from the same time last year. Investors are clearly in a gambling mood. It was the second highest level of monthly options activity in the CBOE’s history. And guess what month tops the charts? In March 2000, 35 million contracts traded hands on CBOE. And we all remember what happened THAT month don’t we? By the way, there’s no strict historical correlation between volume on the CBOE and a top in the market, although I haven’t gone back and done the historical research. There very well might be. What I think you can see here is much more intuitive, and sensible at the same time: investors are swapping a lot of options contracts, using a lot of leverage to either chase a big gain or insure against a big loss. It doesn’t take a regression analysis to connect options volume with major turning points in the market. ***Put/Call Ratio, VIX What were all those options buyer buying? Well, Monday’s put/call ratio was up to 0.71 from Friday’s 0.63. For index option buyers, the ratio fell from 1.72 on Friday to 1.75 buyer. Still more put buyers, but with call buyers on the prowl. For individual equities, the put/call ratio went up from .46 on Friday to .59 on Monday. The VIX is still cruising along under 16. And generally, the VIX does not make gentle moves. Panic is not a gentle thing. It happens all at once. This is good news if you’re going to try and trade the VIX, which I mentioned you’d be able to do last week. Yesterday, CBOE announced that the CFTC has approved a listing for the VIX on the new CBOE futures exchange. You’ll be able to trade options on the futures. It’s a little less straight-forward than buying options on an index. In principle, though, you’ll be able to trade the VIX. How would you use it? Well, the VIX is a barometer of investors sentiment. And right now, even though investors are nervous, the VIX is pretty placid. As investors get less placid, the VIX will go up. Be a call buyer. I did get an interesting question regarding the VIX which I’ve published below (more questions coming later this week). Q: Mr. Denning, regarding your blogs about the VIX and the soon to be listed futures options, wouldn't additional trading activity either dilute or otherwise render the VIX as a gauge of market complacency inaccurate? Since it may become yet another security to be traded not unlike stocks and options themselves? Answer: I don’t think so. Derivatives, which is what options are, are priced based on the market value of the underlying asset. The VIX as an index is still going to be computed the same way. That is, the VIX will still measure the volatility of options pricing. Options prices become more volatile when investors are uncertain and much less volatile when investors are unthinking. And because the VIX measures volatility in options pricing on the S&P 500, options trading on the VIX itself won’t be part of what the VIX is measuring. There will be no tail wagging the dog. What will be worth watching is how the VIX functions as a futures product. Options, of course, look ahead into the future as well, and you use them to make a bet on future price direction. But futures, thus far, are generally used to hedge against the future price directions of commodities, interest rates, and currencies…not financial indexes. Traders try and figure out what something will be worth six months from now…and then see if the futures contract on that item is selling at a premium or discount to what they expect the price to be. It’s a bit of a crapshoot, of course. But the idea is that price trends for some things are fairly predictable…except when they aren’t. And that’s where you make a killing as futures trader, when you benefit from the market horribly miss pricing something based on either a wrong expectation or an external event. Some readers may remember profiting of eurodollar calls two summers ago. That was an example of the market thinking one thing, that rates are going up, and pricing futures based on that expectation. The market bought puts on eurodollar futures. We bought calls, thinking rates were going down even more and prices were going up. There was a big gap in the pricing…it was something the market couldn’t know. That’s where we made the money. We’ll have to wait to see how traders use the VIX. But for now, I don’t think any trading on the VIX will distort its usefulness as an indicator of volatility. ***Commitment of Traders, the BEDSpread, and OEX OEX didn’t make any major moves yesterday, nor did any of its major components. The market waits on Greenspan to give a clearer picture of what he means by “patient,” and probably what he thinks about the dollar and the labor market. None of what Greenspan has to say this week in front of Congress will change investment reality. But it may change investment psychology. For now, it’s worth noting that January volume for options on the OEX 1,27 million. That was up 21% from the same period last year. It indicates the growing popularity of option buying on the indexes…and the growing recognition that the OEX is a good proxy for the “financial economy.” On the gold front, the CFTC released the commitment of traders figures for two weeks ago. What was striking is the near symmetry between the decrease in the net long position of large term speculators and the decrease in the net short position of the commercial hedgers. Large speculators are still net long gold. But they reduced their longs by 22,000 contracts. Commercial hedgers are net short. But they reduced their shorts by…22,000. Coincidence? Perhaps. The commercials are shorter short than the speculators are longer long. Large specs are 95K contracts long while the commercials are 176K short. Yet gold stocks seemed to shrug all this off and advance along with price of spot gold. As I write today, April gold is coming of an intra-day high of $411. Newmont (NEM) is back near $45, where I said it had long-term technical support. And the rest of our stable of gold stocks is in good health. The “Remorse Price” is still $400 folks. Gold has been kicked at, spit on, and derided. But it’s hanging above $400. You’ll regret not buying it on the dips. And with European central banker Ottmar Issing essentially telling currency markets the ECB will not intervene against the weak dollar (the way the Bank of Japan is), watch for an even uglier down move in the dollar this week…and more good news for gold. As for the incredible shrinking greenback…it’s falling as I write. But so far, Asian central banks, Japan’s mostly, are keeping bond prices stable with a steady appetite for U.S. bonds. Japan has over $525 billion of U.S. government securities through November, up 44% from the same time last year. The Chinese own $143 billion worth, and that’s up 27% from same time last year. And by the way, the U.K. has quietly added 35% more to its U.S. bond holdings since last November, from $82.3 billion to $111.7. How long will these CBs support the dollar by buying bonds? We shall see…


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