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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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In order to not be focused on IV spikes on the VIX let’s instead look at our VXV:VIX ratio. What we are seeing here are distinct spikes which seem to be traveling in a descending channel. Take away message – medium term risk spikes seem to be happening in waves and the triggers are becoming more sensitive. Translation – the longer an upside trend persists the more complacent market participants are expected to become. At the same time small downside events are being viewed as more serious than in previous periods.

The latter is particularly evident on the Bollinger version of this chart. As you can see we are clearly getting large spikes in conjunction with relatively small drops on the equities side. Once again – Volar and his quant friends teach us that, although both log normal in nature, VIX/VXO volatility on average is 10% higher than price volatility. On average. But the point of this chart is to show that even annualized volatility may not properly prepare you for the volatility risk you may encounter during extremely complacent market periods.

I don’t have a mathematical model for this but the evidence seems to clearly support this assumption. In other words – the higher markets manage to squeeze the higher the risk of significant volatility dislocations (which may lead to fat tail events) based on relatively minor triggers. So be careful up here and when volatility drops back towards 13 then being long vega to some extent may not be a bad idea.

On the momo side I’m seeing things still holding the balance. We could easily continue painting this divergence on the SPXA50/SPXA200 but watch out once it drops through the 0.80 or 0.75 mark – no matter how high it rode previously, a drop through that line usually leads to a meaningful correction.

Similar view over on the NYSE side – this divergence is becoming more pronounced and once again the uncle point seems to be 0.8 on the ratio.

Our P&F charts tell a mixed tale as well. The SPX appears to be in agreement with my suggested inflection point near the 1525 mark. Right now it’s showing a bearish price objective but that could change quickly if it manages to ride a few handles higher.

The INDU chart meanwhile is looking upward with a bullish PO – however it’s also putting the bulls on notice via a bull trap warning. So in essence things could go either way on the equities side, at least on a short term basis.

Gold has fulfilled its bearish PO – once again our P&F charts serve us well. But I wouldn’t rule out a final drop into the 1520-1540 support cluster.

Silver on the other hand suggesting a much lower price objective and here I believe it’ll run into buying pressure near the 26.5 mark – over the past year this is where buyers have shown to emerge.

 

The FXE which really turned on a dime (just like it did in early 2011) and is now approaching some medium term support near 127.5. Which by the way is what separates it from a drop much lower – the P&F suggests 121.5 right now – we shall see. As you know I have some pertinent thoughts on the Dollar front and in order to see this P&F target on the FXE the Dollar would have to overcome some significant monthly resistance.

If you have been trading our AAPL P&F chart then you have been banking some mighty coin why poor old Steve is probably turning in his grave right now. Just a month ago the bearish PO was lowered to 415 and since then it has once again been lowered to 375. The odds of that happening are not bad given that we just logged a double bottom breakdown. As the saying goes – the higher they fly the harder they fall.

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Cheers,


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 the usual social media waterholes.
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  • 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?

  • https://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?

  • https://evilspeculator.com molecool

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  • captainboom

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

  • https://evilspeculator.com molecool

    Disappointingly few comments on this thread 🙁

  • https://evilspeculator.com molecool

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

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