ImpliedRiskReport: 09/19/07

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

Wednesday, September 19, 2007

Two Sides of the Same Coin

Sub-prime mortgage sellers and hedge funds are inextricably linked. In fact, we think they're two sides of the same coin. Hence, we expect most hedge funds to follow the sub-prime sellers right on out the door.

Here's why. Both were new products, with no regulation. Once investors find out how toxic these products are, no one wants to touch them. It's happened to sub-prime sellers, and it's beginning to happen to hedge funds.

Case in point: Absolute Capital. Supposedly, the founder of the company quit because of a pay dispute within the firm. We don't believe it. Most of the guy's funds are impossible to value because of there is no secondary market for the investment vehicles they hold. Many investors want to withdraw their funds now that the guy is leaving. How convenient: Now he doesn't have to face the slow pain of watching his vehicles waste away to nothing. He can just claim the funds failed because investors withdrew their funds.

Now it's time to screw the customer. First, Absolute Capital has decided you can't take your money out now. Second, they're going to divide some funds up and re-issue two different types of stock. Apparently, one type of stock in will contain performing assets, while the other type of stock will contain the non-performing assets (sub-prime related stuff).

So instead of devaluing their portfolios by half, they're going to split each portfolio into a fund that has half the worth of the original fund and a fund that is worthless.

Man, that really sucks. But hedge-fund investors have signed away their rights like nobody's business. As long as the market rises, no problem. When the market falls, though, it's time to invoke those protective clauses their lawyers slipped in. Just like many sub-prime loan owners ignored the risk they were taking because they wanted in on the deal, so too did hedge-fund investors sign away their rights to the fund manager.

There will be no claims that people didn't read the paperwork, which is what most sub-prime investors are telling anyone who asks. Hedge-fund investors are supposed to be smarter than others, because they have a net worth of more than $1 million. So they can't say they didn't understand the contract, though I'm sure many will try.

But eventually, just like with sub-prime loans, the public will learn what a bad deal they signed into. And people won't want to do it again. At least for another few years, until they invent some new products that are ahead of all regulation.

We'll end with this: Marc Faber, a guy we really like, says the market could fall 30% before it bottoms. That's down to 10,000 on the Dow, and down to around 1,000 on the S&P 500 (SPX). If that happens, people are going to hate hedge funds as much as they hate sub-prime sellers.

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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