Volatility: the Unknown Bull

11/24/2008 12:00 am EST

Focus: OPTIONS

Lawrence McMillan

Founder and President, McMillan Analysis Corporation

Lawrence McMillan, editor of The Option Strategist, finds one way to profit in an otherwise bear market.

A certain commentator on CNBC loudly proclaims, “there’s always a bull market somewhere, and we promise to find it for you,” or something like that. I guess he isn’t looking very hard, because I haven’t heard him mention the biggest bull market of all—at least the biggest one of the past few months. That bull market is in volatility.

Whether you measure it by $VIX, $VXO, or some other measure, it’s been a spectacular bull market, and there’s no obvious sign that it is at an end. $VIX rose from 19 in late August, to an intraday high near 90—a gain of 374% in about two months. That rivals anything the Internet bubble had to offer, or anything else since then—even most of the commodity bull markets of this past year. So, why isn’t everyone (except us and a few other professional traders with whom I am familiar) embracing this bull market? I think most people fear volatility and don’t really want to have anything to do with it.

Since the introduction of $VIX futures (2004) and $VIX options (2006) on the CBOE-owned CBOE Futures Exchange (CFE), ordinary traders of all types can trade volatility directly. With that in mind, “embracing volatility” means nothing more than trading it with bullish strategies until its bull market ends.

As far as overall market sentiment, market breadth has been terrible during the post-election decline. There have been four “90% down days” using “stocks only” data (the Nov 12th action was also a “90% down day” per NYSE-based data). This threw the breadth oscillators into deeply oversold conditions—from which rallies can spring. However, it is going to take at least a couple of days in which advances outnumber declines, for the breadth oscillators to generate buy signals.

The volatility indices ($VIX and $VXO) have risen rather sharply, and that is bearish. In doing so, they reestablished the bearish uptrend in $VIX. There are actually two uptrend lines—a slow-moving one which delineates the larger bear market, and a more sharply rising one emanating from the post-election decline. If $VIX breaks down through those trendlines, that would be increasingly bullish. Volatility derivatives have remained very oversold as well. The discounts on the $VIX futures contracts continue to be substantial, and the term structure is stretched to the upside. Eventually, those will be bullish for the market when they begin to dissipate.

In summary, our outlook remains bearish. We had been prepared to change that opinion if buy signals—especially in $SPX—had risen. They did not, so a new base-building period must begin after new lows. Heavily oversold conditions can spawn short-lived rallies, but they will tire out in the area of the 20-day moving average.

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