The markets will go up and down, and usually it’s not my business why they do it, I am just interested in making my luck with a position on the right side of the trade.
But of course markets don’t move just because of fear and greed, but because of demand and supply. And these two factors are deeply founded in the “real” world.
Michael Roberts, a London based economist with lots of markets experience, is doing an fantastic blog which explains the foundation of the markets with a lot of nicely prepared data and based on a sound economic theory – Marxism. Don’t let us start a political discussion over here, but have a look at his blog, see the data, read his arguments and get a broader view of the market than you would get by just watching the charts and reading the daily news.
If you want to predict volatility, you can place a bet on the option market. Just buy an at the money put and call, and at expiry day you will either win or lose, depending on the actual market move since you bought the straddle and the price you paid for the straddle. To put it simple, if the market moves more than you paid for the two options you will win, otherwise you will lose.
The fair price for volatility
When I look at the S&P500 I could buy or short a straddle with 16 business days until expiry right now for around 70$. That’s the implied volatility.
When I look at the standard deviation of 16 day returns, using the last 30 days to calculate it, it shows me a volatility of around 30$. That’s historical volatility.
When I use my own fair bet KVOL Volatility, it gives me a volatility of about 50$
Now I got three measures for volatility, but which one is the best prediction for future market volatility? And how big will the error (=wins and losses) be if we place this bet over and over again?
Placing an perpetual bet on future volatility using the payback profile of a short straddle will give me an idea on how good historical volatility and Kahler’s volatility was able to predict future volatility. In a perfect world this virtual test strategy should be zero sum game; if not, future volatility is either over or underestimated by these 2 indicators.
If I know which indicator gives me the best volatility assumption, I can use this information to find out, if the current implied volatility of the market is too high or too low. Sell high, buy low…
The chart above gives you an idea on how I did the backtest. I place a weekly bet on volatility, based on a short straddle trade. So if I close outside the of the projected volatility, I have a loss. If the market closes inside the projection, I win. The maximum win will be the price of the volatility indicator at the beginning of the bet, the max loss is the point move within the week minus the price I got for volatility at the beginning of the bet.
The 200 day average is usually considered as a key indicator to tell if markets are bullish or bearish. But can this be proved statistically, or is it just an urban legend handed down from one generation to the next?
Let’s do some studies and find out.
The 200 day moving average
Looking at the chart of the S&P500 index and it’s 200 day average let’s me think that the 200 day average is actually a useful indicator to separate the bull and bear phases of the market. But the eye tends to see what the brain is looking for, so you might have focused on the crash 2008 and the bull market afterwards, but have ignored all these little breaches below the 200 day moving average which happened in between. As a trader I can`t make any money with knowing that there has been a long period under the 200 day average, i need to make my decision as soon as the market drops below the 200 day average.
Distribution of returns above and below the 200 day moving average
The chart above (on the right side) shows the returns distribution of 10 day returns. The green distribution represents the 10 day returns if S&P500 is trading above it`s 200 day moving average, the red line represents the 10 day returns returns when the market is trading below its 200 day moving average. Data from 1980 up to now has been used.
What are the curves telling us?
Sometimes my data provider has not got the data I am looking for. Searching for downloadable csv data I recently came across google spreadsheets. It provides an easy way to get historical stock price data. Save it as csv and use it with your Tradesignal.
The only thing you will have to do is to open a google spreadsheet in your browser, add a formula as shown in one cell and the data will be pulled. Copy&Paste the data to another spreadsheet and save it as csv.
We already had a post regarding the mean reverting tendency of Volatility, now it`s time to make some money using this information.
The VIX volatility index on the chart above looks like an easy to trade instrument, just buy when it is around 10 and sell when it has doubled, tripled, quadrupled…
But unfortunately life is not that easy, VIX is just an index and you will not be able to buy or sell it. You might try to trade volatility using options, but there is a better plan to make money on this wonderful asset class, the VXX, BRCL BK IPTH S&P 500 VIX SH FTRS ETN.
If a bitchy prime minister and a crazy president weren’t enough, for the upcoming months the seasonal chart is also indicating further price setbacks.
Seasonality of DAX
Analyzing the average monthly performance of the German DAX index a distinct pattern of seasonality can be observed. On average June has been down 0.6%, but the big trouble is yet to come.
The chart shows the average monthly performance of the DAX index, using data since 1999.
Each bar of the histogram represents a specific months percent performance. Starting with the dark blue bar in January, the green bar right now represents the average June performance.
Seasonal and Volatility Prognosis:
As you can see on the above chart June always has had a bearish prognosis over the last years. July might bring some relief (the positive magenta bar behind June), but therefore August and September surely got a strong bearish setup. Although the markets have been bullish over the last 20 years, the average combined performance of August and September is -4%.
The average performance of a month is not a good indication for the actual magnitude of the upcoming market move, it just is an indication for its direction.
How to calculate volatility based on the expected return of a straddle strategy has been shown in part 1 of fair bet volatility KVOL.
Using and Displaying Volatility:
KVOL uses the given amount of historic returns to calculate an expected value of an at the money put and call option. The sum of these prices are the historic fair value for implied volatility. It can be used to compare current market implied volatility to historic fair values.
Beside calculating KVOL for a specific return period it can also be used to show it as a projection indicator on the chart.
The example on the chart gives such an expectation channel for the s&P500 at the beginning of each month. The 250 days before are used to calculate KVOL. The line underneath the chart is running KVOL for 13 trading days.
to win, with higher volatility expected: you would have bought a straddle at the beginning of the month, expiring at the end of the month. You should not have paid more than a KVOL for 25 bars (working days to expiry) would have suggested. You win if the chart is outside of the projection at the end of the month.
The shown example uses the 250 daily bars before the beginning of the month to calculate the returns and the price of KVOL. The projected lines represent the winning boundaries of the straddle at expiry.