The recent high regime of volatility may be coming to an end. How could this happen, as fear is currently running high and investors have given up on fundamentals? There are a number of reasons that the market volatility may have peaked. Like a fever it has swiftly risen and the beginning of this year has brought continued high levels above 50 in the VIX. No one can be certain but companies have cut and cut their staff, profits and dividends. But the next batch of earnings expectations is so low that they will be difficult to surprise on the downside.



PhilMost of us spend our whole lives trying to predict the direction of the market. Usually the results are, at best, only moderately successful. Market direction is the most difficult to predict, but as has been discussed here volatility is sometimes easier to predict because there is demonstrably more serial correlation.

Assuming we had both a direction and change in volatility model how would it be used? One way is to look at the cases. They are:

direction volatility

up        up

up        down

down     up

down     down

We could use simple option strategies depending on our outlook for volatility. When vol is expected to rise we would want to be long options. When vol is expected to fall we would want to sell options.

The choice of the option then is controlled by our expected directional outlook. The following table covers the cases:

direction volatility strategy

up         up         Buy call

up        down      Sell Put

down     up         Buy Put

down    down     Sell Call

It is worth noting, in passing, that direction and vol are generally negatively correlated. This implies that the cases up/up and down/down are relatively rare. The other two cases will occur more often.

Perhaps others can suggest different strategies within this framework.

Steve Bal responds:

I would suggest that volatility and direction are both a matter of time. One is obviously a matter of timing the market (as there may not be another time for a top/bottom) and volatility is a matter of time - time that it takes to revert to the mean.

A different strategy may be playing the time frame of volatility. In this exercise on would try to time the daily volatility within the context of weekly/monthly volatility of time.

In this scenario if your daily timing of volatility is wrong there is the possibility that time may be on your side over the longer term. I would never suggest relying on hope (of the longer term) but to reduce/hedge positions if volatility is not on your side.



 Early last spring, Vic and Laurel mentioned they were doing something they had not done before and were making a personal investment in Google stock. I recall this because it reminded me of when Jim Fassel, then head coach of the New York Giants, made a bold statement that the team was on their way to and through the playoffs and on to the Super Bowl. Everyone who wanted to be a part of it had better get on board. Those who were not willing to make that commitment could just get off.

At the time the stock was approximately $350. Around the same time, Jim Cramer devoted a show to Google and said the stock would climb above $500, noting fundamental reasons such as its per-share earnings and its ability to hold a 50 P/E.

Naturally there was the usual back and forth discussion. Google commentary was ubiquitous and bull and bear camps were established to debate the merits of the stock.

Today, Google is $514 per share. One year ago, Apple was $50. Today it is $144. Garmin was around $50, and now it is $80.

The lesson to learn from this: Great stocks are to be owned. Companies who dominate their space are to be kept and allowed to grow. Those who have built fantastic franchise names should be accumulated. Buy Google over Yahoo. Apple over Dell. And most importantly, the speculator should be willing to hold on, eschewing the quick buck in search of the really big gains that can be achieved through diligence and patience.

Easan Katir remarks:

"Pride cometh before.." notwithstanding, I feel compelled to relate that Thursday afternoon after hours I shorted GOOG at 547. Instant gratification feels good! Most trades have elements of shoulda woulda coulda been bigger, better, higher, lower, earlier, later, faster, slower. But not this one. This time I earned my keep! Please forgive this anecdotal, non-counting, horn toot.

Steve Bal writes:

The market favorite GOOG last week became the poster child for a market sell off. Was this the result of great earnings? If I hold average securities whose earnings are average then what chance do my stocks have of rising when GOOG, with great earnings, is selling off?

This impact is significant in the short term as stocks that have earnings releases early this week may come under selling pressure. However, by Wednesday we come up against the firm that has been setting higher records than GOOG, has rallied more than 60% this year, and has more earnings than GOOG. That stock is the new poster child for a great stock, AAPL. 



 The following are the top 10 most read stories at Eight of the stories seem bearish and only two relate to actual company earnings.

I would presume that the readers of these stories must be individuals who have sold recently and are looking for comfort in having made the decision to exit the market at a triple top. I have no idea what that is or what the odds of it being true are but if earnings are rising at 41% for Genentech and profits up 34.5% at Infosys, that is reason enough to buy stocks.

One story is about earnings hopes but the two earnings stories are not hope but fact. Further, all bad news stories have been factored into the current market / index prices and the news in this case offers little factual information.

  1. U.S. stock futures choppy amid renewed housing jitters
  2. Is that a triple top forming in the Dow?
  3. Stocks rise as earnings hopes offset subprime woes
  4. For home-builder stocks, bad news just keeps piling up
  5. Wireless-phone industry tactics criticized
  6. Will stocks feel subprime sting as debt ratings are cut?
  7. Genentech quarterly earnings surge 41%
  8. Infosys profit rises 34.5%; full-year outlook pared on forex
  9. Dollar remains pressured as euro, pound hit highs; yen retreats
  10. Oil stocks weather downturn in crude, oil service downgrades



 In the animal world, ground hogs will make a certain noise to signal that a hawk is overhead. Other animals have similar patterns such as bees doing a dance to signal the source of food. It would thus reason that investments that share characteristics would behave in patterns familiar to people using a value or style method.

Animals left to themselves find a natural stable point between predator and prey but this becomes unstable with people as there is a need to get ahead in the short term at the expense of others. In business this issue is often resolved with methods of price-fixing.

Finally, groups may behave unlike the random investor who will attempt to profit from trial and error in this sector or another. It would appear that a stable group of (long term) investors has come to conclusions about the future of the sector and random (some such as small caps are larger) fluctuations just come with the investment.

Scott Brooks writes: 

Studies have shown that white-tailed deer that are left to themselves, or orphaned (assuming this is after they are weaned) actually do just as well as their counterparts with a mother.

Another interesting aspect to this phenomena is that if you want to keep the buck fawns on your property, it is best to shoot the momma deer and leave the fawns alone. Once the momma goes into estrus, she will run off the button buck (buck fawn). It is believed that this is an instinctual action to that lessens inbreeding. The buttons are left to fend for themselves and find a new home range. They usually travel for several miles, and are disproportionately killed in the hunts. If the mother dies or is killed, there is no one there to run off the button buck, and he will almost certainly stay in his familiar home range. This actually has been shown to increase his chances of survival.

There is a definite cyclical instability in wild in predator prey models. One of the easiest ways to observe this is by watching the rabbit population vs. the coyote population. They definitely ebb and flow opposite each other, never seeming to reach an equilibrium.

The problem is not so pronounced in a well managed whitetail herd. Man is the whitetails biggest predator and man does a pretty good job of keeping the whitetail in check. Due to our ability to use reason and logic, we do a pretty good job of holding the whitetail population in check and stable.

What I find interesting is that in the area's where the whitetail population is out of control, such as cities, it's usually because people are not using logic and reason to solve the problem they're using emotions. I'm reminded of when John Galt said to Dagny, that when you're confronted with a choice and your head and heart are conflicted, always go with your head. ) The point being that in cities, people let their emotions get in the way of doing what is best for maintaining the healthiest most well balanced deer herd possible.

I always find it interesting when city people complain about the deer, but then are all aghast at the idea of harvesting the renewal resource. They always seem to want to try the same tried and failed methods.

This is similar to investing. Most people that invest in the markets really don't have a fixed system that is researched and tested and proven to work. They invest in the emotion of the markets and end up buying the investment that they wish they'd bought last year. As a result, they never reach a consistent equilibrium in the markets and as a result, greatly under perform the 10% long-term positive drift.

The Market Mistress loves to swoop in and devour the portfolio of the unexpecting. But her older sister, Mother Nature, is a vicious task mistress and makes the Mistress look tame by comparison.

Yishen Kuik comments:

I think it has been mentioned here before that classic predator-prey models show cyclical instability instead of steady equilibrium. 

James Sogi writes:

Fish cluster in schools. The edges of the clusters are quite defined. None of the fish want to stray far beyond the pack. Same with traders. Look at how the closing price over the last six days, except Tuesday, clustered together despite wild swings.

Panicking is the worst thing to do around sharks. They don't bother humans or fish, only things that are injured or dead, easy prey. They never bother a strong confident swimmer or surfer, only things that look injured or panicked which is a good market lesson as well.



 The July 2007 issue of National Geographic contains an extremely interesting article by Peter Miller on "Swarm Theory". Swarm Theory attempts to quantify how individual actions of unintelligent individuals develop into the complex behavior of a group. The way ants or bee colonies work together for the good of the group is discussed in detail then how this can be applied to complex human/business systems. For instance, Marco Dorigo, a computer scientist at Universite' Libre in Brussels modeled ant behavior to solve logistical truck routing problems. One company specializing in artificial intelligence applies algorithms gleaned from the foraging activity of Argentinean Ants to manage industrial plant applications.

Upon reading this piece, I immediately considered how these ideas can be applied to the markets, stock indexes in particular. The base factors appear to be similar regarding the unintelligent individual player/relative small group. (unintelligent in regard to the unknown future price movement). Complex group behavior resulting in the changing cyclical nature of indexes, etc. This is definitely something worthy of additional study.

Steve Bal adds:

I have looked at this in the past reviewing such theories as flocking and how ants lay trails for other ants to follow (like the ants found in trees that seem to follow a perfect zigzag pattern). However, most animals have a rapid maturing process unlike humans and thus their environment has a smaller role in their behavior. It would appear that ants and bees act according to pre-programmed genes and evolve over time as laid out by Darwin.

One area of interest to me has been how birds act as a group with group coherency and no need for a formal leader of the pack. I would think this may be similar in the markets as the smart money is the one that makes the most noise and pilots the crowd in its direction of change. 



 Volatility is an unnatural instrument to trade. It moves up as the market moves down and it spends more time down than it does up. Volatility has a way of making its own time. There can be different measures of time but the calendar method is the accepted method (and only tradable one).

The other method of time that matters is the market tempo (as by John Boyd). The tempo may be sending the message to traders how willing other traders are to add to their positions. The tempo also changes with the players involved. And as the markets are experiencing low public participation, the volatility and tempo may continue to remain low.



It's a hard life trying to outperform the stock market indexes. Most of the time these traders do not have tested systems or, if they have done some testing, it is likely that the methodology used has some shortfalls. But let's suppose that everything is fine, and that they have managed to find a niche of market inefficiency which can be exploited by a small flexible trader in and out of the market very quickly. The problem is that a part time trader goes to work in the morning, participates in meetings, travels, etc. Sometimes the boss calls him/her right when the setup is there to be traded! When the system gives a buy/sell signal, he/she is not there to trade it. The lack of consistency is the main issue. For a European trader, it is even worse. Markets in the US open 15:30 European time and close at 22:00. The European part time trader goes home when US markets are open and finds the family "requirements" to be met often more demanding than those of the office work. He/she has to help the kids with their homework, the wife/husband with things to do, dinner time, friends after dinner, etc. Being consistent with the trading plan is almost impossible even for the most determined and focused part time trader. Moreover, when they go on holiday, no trading is possible unless they want to divorce. At the end of the day, although their system works fine and they are very disciplined traders, there is no way to outperform the market simply because they were not there to trade their systems.

Maybe the solution is to give up trading, buying an ETF and spend more time with the family.

Kim Zussman comments:

Yes, but there can be advantages to the part-time vantage:

1. Not looking at markets all day reduces over-trading. The more you look at moment-to-moment moves, the more tempting it is to mistake them for opportunities.

2. Long-term patterns and anomalies are generally more profitable because they integrate more risk and less vig.

3. Personal diversification: Necessarily, frequent losing trades are extremely painful, and it is nice to have other concurrent professional activities which are rewarding. Be a portfolio with a mix of risky and low risk assets, balanced to suit your psyche.

3a. Cover: Being ridiculed and berated by family and friends is diluted when the income stream is not at stake, and they can more easily forgive difficulties of a second vocation if the first is intact.

4. You can easily run your own hedge or mutual fund while drastically reducing cost and customizing risk to fit your temperament.

4a. If you are certain there are others who can invest much better than you, get past your ego and use them.

5. The market needs you, especially if you trade a lot and make many mistakes, to provide liquidity and profits for smart guys on the other side of your trades.

6. The golf rule: Investing/trading can be more frustrating than golf, but it is 1.5 million times more interesting and will make you a babe magnet.

George Criparacos adds:

As a part time trader, I identify completely with the problems outlined and with the response of Dr. Z. I would humbly like to add that there should not be a target to outperform the market.

Scott Brooks offers:

This is a great post by Kim! There is wisdom here for everyone, even those who are not part time traders. Everyone, even pros and day traders, should cut this out and put it in their playbook. I know I am!

Thanks for this Kim!

Scott Brooks further adds:

It is important to remember that outperforming the market (usually thought of as the S&P 500 … the cap weighted index) is difficult. Most pros don't beat the index.

Maybe your goal would be to create an income stream of 3%/year to live on with a moderate amount of growth to offset some of the effects of inflation.

Maybe your goal is to beat a composite index of stocks and bonds (pick the indices that you think are appropriate).

Maybe you're good enough as a personal trader to accomplish the return goals your looking for and to receive satisfaction from managing your money (kind of like a hobby … but one that is profitable).

I have several clients that have me run a portion of their portfolio while they run the rest. The reason in many cases is that one spouse has nothing to do with the money (usually the wife) and the other spouse likes to invest and is really into it (usually the husband). The husband realizes that if something happens to him, his wife is not just going to take over the portfolio and all of a sudden become an expert in something that she has no interest in. So he has me run a portion of the money so that he can be comfortable with my competence and the wife can have a relationship with someone that she knows and has come to trust.

People can have many goals in the markets. It is imperative that you:

1. Identify what your goals are
2. Figure out a methodology that can accomplish those goals
3. Figure out if you have the time to work that methodology
4. Make sure that a fail safe is in place (i.e. work with a professional if your spouse is not interested, or work with your spouse)
5. Figure out if you have the competence to accomplish your goals
6. Be able to back test your system in the bad times (everyone was bragging about their genius in the 90's … but seem to have lost half their new found IQ since)
7. Have a playbook for how to handle different scenarios (especially what I call lifeboat drills)
8. Be willing to admit that they may not be able to do it
9. Other things that are important that I'm sure I'm missing
10. Make sure that you're having fun if you meet all the above criteria

Steve B. adds:

The part time trader is not the problem or the issue. The part time trader has at his disposal an arsenal of conditional orders that are set to fire on almost any imaginable market condition. It is the conditions that the part time trader has not taken the time to identify.

The issue in this case is the strategy. A part time trader will trade like "the trend is your friend." In this case the trend is what is hot and what strategy is in vogue. With the ever-changing cycle of trends, there is no possible way to get ahead in this type of trading. I would also argue that the part time trader is price focused - he does not care about volatility, interest rates, currency fluctuations, emerging markets, etc. due to the nature of his game "part time."

The part timer finally is apt to find shortcuts in order to make up the difference in time. The problem with shortcuts is that they run near to the edges of steep cliffs.

Dylan Distasio responds:

The issue in this case is the strategy. A part time trader will trade like "the trend is your friend." In this case the trend is what is hot and what strategy is in vogue. With the ever-changing cycle of trends, there is no possible way to get ahead in this type of trading. 

I would disagree with this statement as someone who has traded both fulltime as an intraday trader, and who now trades part time with a different vocation during business hours (and a longer trading time frame for a number of reasons). The part time trader is not tied to trend following strategies, and is certainly not obligated to follow what is hot and in vogue. They are just as capable of fading the herd as a full time trader or coming up with any other strategy to try within an interday time frame.

I would go on to argue that trend following strategies are capable of making money long term. The No Load Fund X newsletter which combines a relative strength trend following strategy with mutual funds (or more recently ETFs) has consistently beaten the S&P 500 since 1980 as audited by Hulbert Financial Digest.

In any case, they are not tied to the trend. There's nothing preventing them from following whatever strategy they wish. Practical considerations usually exclude the intraday time frame as an option for the part time trader, but they can use their ability to sit on their hands and cherry pick within a longer time frame as a strength.

I would also argue that the part time trader is price focused - he does not care about volatility, interest rates, currency fluctuations, emerging markets, etc. due to the nature of his game "part time."

I would argue that the part time trader should care about all of these things. Speaking for myself, I certainly do.

The part timer finally is apt to find shortcuts in order to make up the difference in time. The problem with shortcuts is that they run near to the edges of steep cliffs.

The part timer who is serious about attempting to beat the market should realize the amount of work required to do so. I think most of the ones who are able to trade part time and consistently beat the market are combining a lot of hard work after hours with their experience, and a willingness to constantly learn.

J. Klein offers:

Respectfully, I would tend to disagree. Part time vs. full time is not a question of strategy. It is, I feel, an acknowledgment of one's limitations.

Many will disagree, but I find that trading is mainly hard work. If you work hard on learning the market and about yourself, eventually you will work out some small strategies that leave you with a few more coconuts in the evening than you had in the morning. I am old enough to have seen more than one dumb young person get decent rewards, if they hung around long enough and are honest and hardworking.

The market is very large and there are many opportunities, but a part timer may take a relaxed view and let most of those golden opportunities flow away. Existing in a less pressurized environment, he may engage in only a few situations, and follow them more carefully. He trades part time, but his mind keeps working full time (how can one avoid it?) so he may be doing more thinking on each trade. More thinking, less pressure, less fear = better results, hopefully.



I came across Gray Television, which operates CBS and NBC television stations, and which was recommended in Barrons this week. Its philosophy of operating stations in state capitals seems to me the soundest thing I've heard since such capitals always increase in population, influence, and commerce. According to Nock's idea, the only job that matters in the U.S. is the Secretary of the Interior. When I visited Brussels in 2001 and saw the E.C. starting there, I predicted similar growth to Washington. I thought that the real estate market there would have similar growth to that of Washington from the 30's, as more and more plucking of geese was done there. I wonder what other companies are so situated to profit from increases in capital activity.

There is much talk about this being the longest period in market history without a 10% decline, and that it's going to come soon. Noticeably absent is the testing relative to survival statistics that of course shows a hazard rate decreasing after a threshold. But all are waiting for a 10% decline and presumably they will be ready to buy when it comes. Of course, like the 9% decline in May, it will probably come just short of that, not to give them a chance, but if it does come, there should be some nice buying there. There is also talk about the Bernanke put not being as high a strike price as the Greenspan put. Hickey and Faber and R. Forsyth are also very bearish, and this time it is not because of Iraq-as in the previous Abelson world's record for consistent bearishness, comparable to the Caltech streak, or the first rounds lost in Tennis streak–but because of declining world liquidity caused by oil price declines. Discussions of the broken window effect are there, but there is a total obliviousness to the fact that when goods get cheaper, real income and real wages increase, and this raises individual and total wealth. Similarly it's not the GNP measurement problem that the broken window effect is designed to capture, but it is rather the loss in total output that occurs when a broken window is replaced with a new one due to the opportunity cost of fixing it.

With all the talk about mechanical systems that find overvalued stocks–which are all as we have posited many times broken because of faulty data, ever-changing stocks, and low priced effects–it would seem apt to find groups of stocks that are sold down hard by such things as mechanical signals triggered by earning lapses, so that a bull move similar to those by Drew (when he was on the long side, based on and triggered by Little's bearishness before his bankruptcy) in the 19th century could be engendered. The statistics on moves in short interest classified by individual stocks would seem to be a good foundation for such maneuvers.

I am reading Our Brave New World by GaveKal Research and it contains a mass of untested assertions from a money making persona similar to their view that companies that don't manufacture but are designers do much better than manufacturers. This would seem capable of testing via changes in asset levels, and return on capital figures, and one doubts that it would bear out the GaveKal thesis. But their idea that intangibles, knowledge and education, and free trade are the key to prosperity seems to put them on the weather gage.

Vic further adds:

Read this chapter on lognormality, which shows the intricacies of even preliminary work.

Steve B. comments: 

Discussions of the broken window effect are there, but there is a total obliviousness to the fact that when goods get cheaper, real income and real wages increase, and this raises individual and total wealth. Similarly it's not the GNP measurement problem that the broken window effect is designed to capture, but it is rather the loss in total output that occurs when a broken window is replaced with a new one due to the opportunity cost of fixing it.

With all the talk about mechanical systems that find overvalued stocks–which are all as we have posited many times broken because of faulty data, ever-changing stocks, and low priced effects–it would seem apt to find groups of stocks that are sold down hard by such things as mechanical signals triggered…

"The government's statistic is broken" is often heard from the caves of bears as they run out of hard evidence and resort to mud slinging and conspiracy theories. Just last week, the ADP data showed a market with jobs lost only to be replaced by the official numbers of job growth. The latter propelled the markets as the ADP shook out willing sellers and those who thought they were getting some kind of inside information from the ADP numbers.

Some mechanical systems are the shortcuts of part time traders and the sellers of fortune. There are opportunities in stocks that trade away from their peers only because they have been sold hard due to some trivial news event that caused a large enough price move to trigger mechanical systems. The price based trader will always be with us and I suspect some have already found some of their trigger points, such as was done years earlier by Market Makers holding the "book."



The case for deception in markets is an interesting one, but for several reasons I hypothesize that what we are seeing may be self-deception:

Deception on such a large scale would imply that some kind of collusion is involved by market participants as no one source of participants is large enough to move a liquid market.
Let’s say that last time there was a particular memorable event a related market moved sharply in a particular direction. Those who were stung the previous occasion are likely to liquidate their positions on the basis of ‘once bitten, twice shy’. Thus they move the market in the opposite direction to last time prior to the event in question.


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