ImpliedRiskReport: Oils '07

What is Implied Risk?

Implied Risk (IR) readings are really a translation of certain data elements produced by the listed options market. We use option implied volatility to produce expected trading ranges for issues, like equities, indexes and ETFs.

These trading ranges have unique characteristics that are based on the data's format. Option implied volatility is expressed as a function of the normal curve. Therefore, we can apply normal curve characteristics to our understanding of an issue's action within its own expected trading range.

The normal-curve characteristic that concerns us most is reversion to the mean. Here's how we look at mean reversion: The further away from the mean, the more likely the next move will be back toward the mean.

It breaks down like this. There are six standard deviations in the normal curve, three above the mean and three below the mean. Normal curve theory states that 2/3 of an issue's price points will be within one standard deviation -- up or down -- of that issue's mean price.

Take it to two standard deviations, up or down, and normal curve theory expects a full 96% of price points to be within that range. Price movements outside of two standard deviations of the mean are rare events.

Here's how we look at it: An issue that is two standard deviations from its mean price on a 90-day basis is a perfect candidate for reversion to the mean. So we look for issues that have reached extremes, both as trading/investment ideas and as a harbinger for where the market could be heading next.

Our Favorite Market Books

-- (2000) When Genius Failed: The Rise and Fall of Long Term Capital Management, Roger Lowenstein
-- (2000) Active Portfolio Management: A Quantitative Approach for Producing Superior Returns and Controlling Risk, Richard Gringold and Ronald Kahn
-- (1996) Against the Gods: The Remarkable Story of Risk, Peter Bernstein
-- (1994) Stocks for the Long Run, Jeremy Siegel
-- (1992) The Winner's Curse: Paradoxes and Anomalies of Economic Life, Richard Thaler
-- (1989) Market Volatility, Robert Shiller
-- (1986) Options As a Strategic Investment, Larry McMillan
-- (1973) A Random Walk Down Wall Street, Burton Malkiel
-- (1923) Reminiscences of a Stock Operator, Edwin Lefevre
-- (1922) The Stock Market Barometer, William Hamilton

Saturday, August 4, 2007

Oils '07

We like the oils when they move one standard deviation below their respective 90-day means. We don't want to wait until they move two standard deviations below their respective means -- if they do, we'll buy more. We'll sell only once these issues move significantly beyond two standard deviations above their mean prices.

If you bought the oils when we said to in January, you would have made 50% on oil service and 27% on large oils by the time we said to get out in late June.

We saw a great opportunity to get into the oil issues back on January 16. In fact, that week's issue of the DYR Report was titled "Oil Opportunity." We said: "The rotation out of oils and into techs has been almost too perfect. Nasdaq 100 (NDX) has rallied back into Zone 5 as the oil service indexes have slipped into Zone 2. Both groups are due for a little reversion to the mean. But we'd buy the oils before we'd sell the techs." More: "Three months ago, the DYR Oil Sectors also made Zone 2. Two months later, those DYR Sectors were solidly in Zone 6." At the time, the Oil (XOI) index was at 1,11o and the Oil Service (OSX) index was at 185.

We noted the strength in the oils as the year progressed, but we didn't really issue a sell signal until the entire stock market turned down in June. On June 25, we wrote: "All of the broad-based indexes have pulled back into Zone 4. The oil indexes remain in Zone 6. Gas prices have declined recently. If the oils pull back too, we'd buy them again at 90-day neutral. There's still a war in Iraq. But the market has rallied right along with the oils, so we'd expect it to pull back with them as well." At the time, Oil (XOI) was at 1,412 and Oil Service (OSX) was at 278.

The gain in XOI was 27% and the gain in OSX was 50%. Send us an email and we'll send you a report that contains all of our comments about the oils so far this year.

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How We Use Implied Risk to Trade

Implied Risk readings are used to denote percent deviation from trend. We're looking for issues that have deviated more than one standard deviation from trend, on the assumption that soon the rule of reversion to the mean will force the issue back toward its trend line

But the real value of Implied Risk becomes apparent only when you create compelling comparisons among issues that share similar characteristics. For example, we group together all the broad-based indexes, such as S&P 500 (SPX) and Nasdaq 100 (NDX), to give us a picture of the overall market. Then we group together all the sector indexes, such as Broker/Dealer (XBD) and Housing (HGX), to show us which sectors are rallying and which sectors are falling. Finally, we group issues by thier relation to thier means, so we can tell which ones have moved to lower or upper extremes.

Once we've established the relative strength of the market and its various sectors, we can determine the appropriate trading strategy. The most leveraged trades, such as buying calls or buying puts, are reserved for moves to extremes. Our most basic strategy, the buy/write, is applicable at all times except during a move to the upper extreme.

We look at the market from the top down. Market, sector, stock. We like to buy when all three are more than two standard deviations below thier means, and we like to sell when all three all more than two standard deviations above their means. We call it buying low and selling high.

Three Months Ago

Here's the front page from The DYR Report ($600/yr.) on June 18, 2007:
STRANGE REBOUND
Stronger bonds had the stock market on a strange rebound last week. It’s strange because most indexes and sectors are near Zone 6. There is so much liquidity that pullbacks don’t even reach 90-day neutral. Overall, the market’s action doesn’t match the data. We don’t like it.

We do like gold stocks. The golds gained about one standard deviation last week, and now they’re back to 90-day neutral. If the market does pull back significantly this summer, golds look good.

Here’s how crazy things have gotten. Posco (PKX), the fourth largest steel maker in the world, plans to expand its output next year by 30%. The company says it has orders for steel plates from shipbuilders. Things is, both PKX and the four largest shipbuilders are based in South Korea. Can you say corruption? Lots of risk here.

PKX, like the rest of the steels, has doubled over the past year. The stock remains more than 100% overbought on a 90-day basis, about the same as Steel Producers (STQ). We’re no economists, but shouldn’t the tightening of credit worldwide hurt these guys? Implied volatility (IV) expectations for steel stocks are among the lowest in the business, which makes long-term puts relatively cheap.

Among the sector indexes at the bottom of the DYR short-term rankings, the only one we like even a little is Corporate Bond Fund (LQD). Two other sector indexes are in Zone 2 – DJ Equity REIT (DJR) and Airline (XAL) – but we think they belong there. When there are no good oversold groups to buy from, don’t be buying.

Finally, we noticed that XAL has dropped below 50. When will it be time to buy again? We’re looking for a big sell-off, where maybe a big player says they’ll never own airlines again. It happened to the gold stocks just six years ago. We say buy long-term if XAL hits 25.

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