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Fresh Baked Mandelbrot
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Fresh Baked Mandelbrot

by The MoleMarch 3, 2013

Last week I suggested that the current trend may be nearing its roll over point – in particular if the current inflection point at ES 1524.5 could not be overcome. To that end I would like to share a more in-depth perspective as my long term charts remain ambivalent and do leave room for a continuation of the advance in equities:

First up let’s be absolutely crystal clear about the fact that as of right now the trend remains intact. As a matter of fact the weekly NLSL at ES 1491 was briefly breached but instantly reversed and then some. So far so good – but when putting this chart into context with the next one then it leads us to the beginning of today’s little tale:

And here it is – fresh baked Mandelbrot – can you smell it? Of course I’m talking about the rise in volatility on the IV side – more precisely the huge spike on the VIX. A 50% jump in one week in conjunction with a 3.2% drop on the SPX (i.e. 50 handles on the ES) is hardly justifiable and either is a representation that risk assessment is being miscalculated (see Taleb, Mandelbrot, et al. – must read article here which I found by pure accident) or that we have reached a level of complacency which now regards any type of downside correction as catastrophic and a potential trigger of a six sigma event.

So let’s pause here for a second as that alone should make us worry. Unless these types of events do not lead us to a more realistic re-evaluation of our current risk models then I see quite a bit of blood and tears looming behind the horizon.

Before we take my thought any further let’s go over some basics. A bit over one year ago Volar put together a pertinent post as a follow up to a previous article which I think has been completely under appreciated as it conveyed some inherent truths that many of us may end up forgetting in the routine of our daily trading pursuits. In a nutshell the take away points were as follows:

1) We know that the market has kurtosis. It tells traders to buy low and sell high, and that little moves are common. However reality is that markets move in jumps (i.e. rockets – please refer to my post on market weather – see the ‘evil‘ page for more favorites) with in between periods designed to draw in the gullible.

(2) Volatility on both SPX and VIX is lognormally distributed and VIX distribution exceeds that of the SPX. Which means implied volatility always trades at a premium to actual SPX volatility. Well, there you have it – think about that next time you buy options.

(3) All of this proves that William Eckhardt and Nassim Taleb’s beliefs. The market is more exponential than you will ever believe. So find a way to use this to your advantage [or at least know when it’s time to step aside – recall my post titled ‘caveat emptor’ – again check my ‘evil‘ page].

(4) You must understand this to survive as a trader. How can one have an opinion or expectation on the market if one does not understand how markets work?

(5) Nothing is ever simple, but it probably is seasonal.

Let me add to the above that seasonally the probability of a 50% spike in IV in February was very low. We know that the market is kurtotic but last week it suddenly went super lepto kurtotic on the turn of a dime. To quote Volar once more: For those betting on mean reversion, you may win often (in little bits/pieces), but you will be bankrupt if you dont know how to get out and STAY out.

But this is just the beginning – seasonality in kurtosis is one thing but we should also address how IV triggers shift over time. Volar finished his essay by summarizing that distributions can be seasonal as well as conditional. Let’s talk about the conditional part in more detail:

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About The Author
The Mole
Mole created Evil Speculator amidst the chaos of the financial crisis in early August of 2008. His vision for Evil Speculator is a refuge of reason, hands-on trading knowledge, and inspiration for traders of all ages and stripes. You can follow him and his nefarious schemes at various social media waterholes below.
  • Schwerepunkt

    Wow. I need some time to digest this one. 

  • http://dartht.blogspot.com/ Darth_Gerb

    Today is not an accident. There are no accidents. We have not come here by chance. I do not believe in chance. When I see three indexes, three geniuses, three comments. I do not see coincidence, I see providence. I see purpose. I believe it our fate to be here. It is our destiny. I believe this week holds for each and every one of us, the very meaning of our lives.
    – Gerb

    http://2.bp.blogspot.com/-kF7s5Yy6wFA/T1gt8sV1aZI/AAAAAAAABbE/kbha8hfECGM/s1600/morpheus.jpg

  • RacerXX

    Wow great post. Def rich stuff.. need to consume in more than one sitting.

  • AmazingLarry

    “we have reached a level of complacency which now regards any type of downside correction as catastrophic and a potential trigger of a six sigma event.”
    Just to clarify, this would be a 6x standard deviation move. As a trader, our job is to identify and capitalize on the move itself, rather than try to figure out what the “trigger” could be?
    Been sort of licking my chops for an updated Market Maker chart, Moleman. 
    Wicked stuff, thanks.

  • http://dartht.blogspot.com/ Darth_Gerb
  • http://twitter.com/RolloTomasi3 Rollo Tomasi

    Yeah, I think Taleb is on to something. “Information is bad for knowledge.” Also “It takes considerable effort to see facts (and remember them) while withholding judgment and resisting explanations…information is costly to obtain…the same condition that makes us simplify pushes us to think that the world is less random that it actually is”.Moving on to related things, can the term ‘fractal’ be borrowed and expanded? Could we suggest that a short-term daytrade, in terms of volatility, could be a ‘fractal’ of broader, longer-term market action in Taleb’s uncertain world? If so, and if ‘let your winners run and cut your losers short’ has any validity, then wouldn’t you want trailing stops built into your system? Let me ask this; does Geronimo use trailing stops? If not, why not? Wouldn’t you want that outsized, hard-to-predict move, when it does come, to allow you to catch 20 ticks or more instead of 10? Wouldn’t this be using exponential volatility to your advantage?

  • http://evilspeculator.com molecool

    cute :-)

  • http://dartht.blogspot.com/ Darth_Gerb

    using Taleb’s turkey example… information about how the turkey is being fed, and cared for every day is useless.

    KNOWLEDGE, that next week is Thanksgiving – is dam near priceless.

  • newbfxtrader

    Good stuff mole. Heavy. Yellow alert? When we gonna hit Defcon?

  • http://dartht.blogspot.com/ Darth_Gerb

    ..for the ladies, got to remember Soccermom.

  • Skynard

    Went long the Yen on the hourly BB.

  • Joe_Jones

    Outstanding post Herr Mole.

  • Skynard

    Watching the 3.4 neck line, still short.

  • carmelbythesea

    Did Volar ever rerun those charts with just the QE years?

  • Joe_Jones

    and great article btw. Thanks

  • http://dartht.blogspot.com/ Darth_Gerb
  • Skynard

    Spoos taking heat:)

  • http://dartht.blogspot.com/ Darth_Gerb

    BTFD.
    Yen on the other hand, is flat-lining with Mesas (5 min).
    accumulation me thinks.

  • captainboom

    ZFX appears to be down.  Anyone else?

  • http://evilspeculator.com molecool

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  • captainboom

    Thanks Mole.  BTW, excellent post.  This one will be in the ‘review often’ category.

  • http://evilspeculator.com molecool

    Disappointingly few comments on this thread :-(

  • http://evilspeculator.com molecool

    ¤ø„¸¸„ø¤º°¨¤ø„¸¸„ø¤º°¨ 
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    ¸„ø¤º° B A K E !“°º¤ø„¸
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  • http://evilspeculator.com molecool

    No it’s running. Just needs a bit of time before the signal kicks in….