ImpliedRiskReport: 08/16/07

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

Thursday, August 16, 2007

Told You So

You gotta love the Merrill analyst who took Countrywide (CFC) to a sell from a buy he issued two days earlier. Hopefully the psychological scars he absorbs from becoming an industry laughingstock will last until the end of his days. Can you say boiler room?

We've been harping since May about the bad prospects for the market in August. Here's what we said about the market in May, June and July:

May 7 -- "We'd guess that most of the gains for this year have already been made. The rest of '07 will be about holding those gains."

May 14 --"This rally is bad for the economy. The groups that are strongest -- commodities, cyclicals and defense -- are the ones killing the country. When all is said and done -- we'd say about August -- it'll be bad."

May 21 -- "We'd stay away from the weakest group in our rankings, though. REITs have been crushed, but we suspect there's more to come. In fact, we'd short Housing (HCX) again while it's around 90-day neutral. When we finally do make it back to Zone 1 this year, we think the housing stocks will be the downside leaders. REITs too."

May 29 -- "Hope you made some money the the last couple months. The next couple months should be a time to reduce your positions heading into August."

June 4 -- "Broker/Dealer (XBD) is one of the strongest sectors again. All is well with the market. We'd get out now. Sell in May and go away sounds about right...In three months or so, the bonds will be near Zone 6 and yields will be weak...We don't believe the economy warrants such an impressive run. It's all about liquidity...There is lots of risk in this market. We're looking for a Zone 1 reading in late August or early September, when the market usually has its worst days. Then we'll talk about buying."

June 11 -- "The Fed says it won't lower interest rates, but the market rallies anyway...This market doesn't want to die yet. Wait until August...We expect bonds to be overbought and yields to be oversold by summer's end."

June 18 -- "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."

June 25 -- "We're halfway through the trading year, and we may have seen the market highs for '07...The true repercussions from the housing bubble are starting to be reflected in the financial markets. And the market is coming off a nice Zone 6 reading. It'll be a long summer..We don't see how banks can get out from under the mortgage mess until some losses are taken."

July 2 -- "The Fed didn't clear things up much last week. Looks like they wouldn't mind if the stock market cooled...The sub-prime mortgage fiasco isn't going away. In fact, it'll get worse. Bank and housing indexes have dipped into Zone 2. They should lead the rest of the market down."

July 9 -- "The DYR Phase Chart has bounced back up to -21 in Zone 5...We still think the new trend is down toward 90-day neutral. A sideways market this month, or a quick drop soon, would get us there. Then we'll see what happens in August and September."

July 16 -- "Did good retail numbers really send the Dow Jones Industrial Average (DJIA) up 250 points in one day? But didn't Home Depot (HD) and Sears (SHLD) warn? Looks to us like there's a bunch of people spending a bunch of other people's money on risky stocks...We're just waiting for Broker/Dealer (XBD) to start leading the market south...Consumer (CMR) and Retail (MVR) are among the weaker sector indexes on a 90-day basis. We wouldn't be surprised to see these indexes lead the fall as we get into August and September."

July 23 -- Headline: Time For Puts. "Broker/Dealer (XBD) has broken down...We think the market follows the brokers. That means it's time to buy puts on the market and certain sectors...As far as strategy goes, look at puts on the stronger indexes (SOX, QQQQ), foreign ETFs (XEX, CZH) and financials (XBD, RKH)...time to take profits on Gold/Silver (XAU). The index is in Zone 6, just barely, over both 90-days and 10-days. It's hard to see the dollar falling lower. If the market tanks, golds will fall too."

July 30 -- "There's another one or two standard deviations to fall before we call it a wipeout. Our last Zone 1 reading: March '03."

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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