ImpliedRiskReport: 08/19/07

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

Sunday, August 19, 2007

Zone 2

The DYR Phase Chart has fallen to +24 in Zone 2. Most of the broad-based indexes have eased back up into Zone 3. The financials are leading the bounce. Bank indexes are among the strongest in the market now, over both 10 and 90 days. Broker/Dealer (XBD) has climbed up to the middle of Zone 2, and it's one of the leaders over the short term. Maybe this bounce will take the market back to 90-day neutral, but we suspect there's at least another leg down before the market stages a comeback. There's very little blood in the water. We're still looking for Zone 1.

The unwinding of the Japan carry-trade has taken Japan (JPN) to the deepest depths of Zone 1. This looks like a buying opportunity here, especially if we see more weakness in the index this week. As a result of the unwinding, short-term rates have gone ballistic. 13-week Interest Rate (IRX) is 93% overbought over 90 days and 185% overbought over 10 days. Those numbers have been reached even with a whopping implied volatility (IV) of 40, about twice the index's average. Longer term bond indexes have reached Zone 5, indicating there's a ways to go. The market probably won't find a true bottom until the bonds have found their true top.

The DYR Sector Rankings show the uniformity of this decline. When you can't sell what you want, you sell what you can. Three-fourths of the 20 DYR Sectors are in Zone 2. The other five sectors are less than 1/2-standard deviation stronger than the rest. There are no DYR Sectors above 90-day neutral, and none are in Zone 1. The group we're liking now is the oils. Last time the oil service stocks dipped down into Zone 2, they nearly doubled within six months. If money pours out of the financials, we'd expect a large chunk of it to end up in the oils (and maybe the techs).

Here's another sector we like: Defense. The defense indexes (DFI, DFX) didn't get hit as hard as most, and they're rebounding nicely now. They carry some of the lowest IVs among indexes and ETFs we follow. That means they carry less risk on a relative basis. Like consumer staples and drugs, the preferred type of issue for those abandoning riskier positions. Plus, we don't see a quick withdrawal of our forces from Iraq coming soon. The place is an absolute mess.

Finally, Gold/Silver (XAU) touched Zone 1 during intraday trading Thursday and then rallied. We suspect you'll get another chance to buy in the lower 120's before this is over. The index is still in Zone 2, so it's already a good buy. Buy some now, save some cash for buying more later.

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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