ImpliedRiskReport: 08/08/07

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

Wednesday, August 8, 2007

From the Archives: The Zone System

Each Wednesday we'll reach back into our 25-year archive of commentary by our founder, Jim Yates. Here's an excerpt from 1994's The Yates Guide to Profitable Options Investing:

The Zone system is based on an analysis of the deviation of a stock's price from it's trend. Zones are the six areas under a normal bell-shaped curve defined by standard deviations. Zone 1 represents the area that is between two and three standard deviations below the mean. Zone 6 is at the other extreme. Zones 1 and 6 are the farthest points from a stock's mean, or where it has historically migrated during reversion to the mean. The mean is the vertical line bisecting the normal curve and it's called the trend.

Because it's future distribution we're concerned about, the implied volatility for the stock is used to estimate that standard deviation. Implied volatility is the annualized standard deviation that justifies the current options price. This is a particularly important statistic because it's the only market-derivable statistic that represents a forecast of future price movements.

We use two time frames for analysis, 10 days and 90 days. There's nothing magical about these two time frames, they were chosen because they fit the profile of a short-term trader and options hedger.

In the process of the evaluation, each Zone is expanded to a 33-point scale. A stock that is at the three standard deviation limit, or Zones 1 and 6, could then be said to be either 99% oversold (Zone 1) or 99% overbought (Zone 6).

The beauty of the Zone system is that it's easy to use. By simply identifying which Zone a stock's in, you can formulate a strategy. Next week we'll describe a tool we've named the Options Strategy Spectrum. The similarity between the Options Strategy Spectrum and the normal distribution curve is no coincidence. They're the same, but we've broken down the bell curve into Zones that delineate which stock-and-options strategy is appropriate at the time. Zones 1, 2 and 3 are below the mean (or oversold), while Zones 4,5 and 6 are above the mean (or overbought).

The Zone system is simply another way of looking at the market, but from a risk perspective. One advantage of the system is that it allows direct comparison of the overall market, market sectors and individual stocks at the same time. Every market index, sector index and individual issue will visit each Zone over the course of time. When issues move to the extreme Zones, the probability is high that the next move will be back toward the mean, assuming the volatility estimate delivered by the market proves reliable.

The Zone system can be compared to a map. While a map may be of significant benefit in determining where you are headed, it's most important contribution is detailing where you are right now. If you don't know your current location, it's nearly impossible to locate the path to your desired destination.

Upset Stomach

The market is acting like it ate some bad sushi over the weekend. Things are jouncing up and down inside, when usually it's a smooth ride. You can pour some Pepto on the problem, but eventually it's going to have to be processed on out. You know how that goes. But then the market will feel all better, and we'll be rallying in the fourth quarter.

First we gotta get rid of this bug. We don't think it will end until the bond ETFs and the yield indexes move to extreme extremes, like Zone 8. Reason: The vehicles we use to follow these moves carry low trading volume, so their implied volatilities (IVs) are underestimated. Right now, bond ETFs -- which carry the more reliable IVs -- are less than one standard deviation above their 90-day means. Plenty of room to rise, which is bad news for the stock market.

"Rumors have been floating that many Wall Street firms have forged agreements not to mark down the value of securities on their balance sheets in order to cease further disruption and help smooth out their future earnings. Such action may give firms more time to work out bad debt or rejigger their portfolios, but only time will tell if that serves to solve the broader credit woes or will only result in magnifying the problem." -- Mark DeCambre, TheStreet.com

Interestingly, this was the last paragraph in the article. Yet it's the most important item. How could it possibly help? The problem is not going away. People will lose their homes, the banks will have to take them back. But even before all that happens, these bonds will be worthless. Remember, this is going to end with one of the biggest blowouts -- percentage wise -- of all times. Buy the stock market here at your own risk.

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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