I have never witnessed a day like today in my 20 years of actively trading the stock indices – S& P 500, Nasdaq, Russell 200 and Dow futures. In reality, this was a “Perfect Storm.” In the future, I think this will happen over and over as the three main reasons for May 6th volatility are boostingï»¿ ï»¿momentum all the time.
First, public complacency hasn’t been this high since the summer of 2007. Every new government program and bailout strengthens the warm and fuzzy investor psyche that permits us to believe everything will be all right. The Volatility index measures the price paid of protecting your stock portfolio through the purchase of put options. Put options are like buying portfolio insurance. If you hedged your $300,000 stock portfolio it would have cost you approximately $8,500 in put premium to protect the full amount of that portfolio through June, from any downside vulnerability. That same insurance policy in the afternoon would have been worth $23,625. Considering the value of your portfolio equaled the decline of the stock market, you would’ve lost 3.25% on your $300,000 or, $9,750. The difference between the $8,500 paid up front versus the current portfolio’s value of $290,250 plus the current value of the insurance policy $23,625 means that your net worth on the stock market’s biggest point loss day in history would have actually INCREASED by $5,375. The increase in the VIX is the reason for the inflated option premium and the magnitude of the rally of the VIX bears confirmation to the market’s general complacency.
Secondly, all of the markets are tied to each other. That’s why we are Commodity AND Derivative Advisors. In the age of electronic trading, one issue always affects another one and that one in turn, affects another on and so on. Every trade in an outright market like the S&P 500, Euro Currency or, Japanese Yen will have an effect on any market it is realated to. This has, in effect, developed one giant butterfly effect. In the age of algorithmic trading, where the minutest of market inefficiencies are exploited by aggressive capital placement, strange market moves will become self fueling. Many of these models use markers based on the model’s expectation of, “normal,” relationships to its data points. When things get pushed beyond the model’s, “normal,” expectations you have a case of, “If you liked stock ABC at $12 a share, you’re going to love it at $4 a share.” There were at least two stocks in the S&P 500 that traded to 0, today. This means they were broke, bankrupt, didn’t exist. Two Fortune 500 companies disappeared on someone’s lunch break and by the time the employee got home from work, no one knew the difference. Twenty minutes of electronic market butterfly effect.
Finally, as the market began to drop, the media was showing the Greek police force in full riot gear after passing their severe austerity vote in an attempt to acquire financing from the European Union. Furthermore, the context of the day’s discussion among the talking head TV pundits was the doom and gloom surrounding the collapse of the European Union, civil protest and bankruptcy in Greece with the specter of Spain’s impending default as a backdrop. Doom and Gloom sells. Traders, both institutional and retail are listening to the end of the world as we know it while watching the stock market meltdown and trading programs are ticking off one sell order after another in an attempt to be the first ones to market with their orders. The pursuit of greater bandwidth on their data feeds, faster processors in their computers and deeper levels of quantifiable algorithms put them in the lead in the race to the bottom and right back up. Welcome to the new age of 24 hour doom and gloom media coverage, total connectivity and computer programs replacing common sense trading. We specialize in common sense trading.
This methodology is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. This method is meant for educational purposes and to explain the correlation between the commercial’s trading and its effect on creating turning points within the commodity markets. The commodity markets employ a high degree of leverage and may not be appropriate for all investors. There is consideral risk in investing in futures. The information contained herein comes from sources believed to be trustworthy, but are not guaranteed as to accuracy or, completeness.