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Futures in Volatility includes several sections: Market Summary and Analysis, Trading Strategy Ideas, and Events. Market Summary and Analysis includes commentary related to VIX, VIX futures and other volatility products, as well as charts and data related to these markets. Trading Strategy Ideas features strategies focused on trading volatility products. And, Events features upcoming CFE and Chicago Board Options Exchange (CBOE^®) conferences, seminars and webinar presentations.

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VIX^® Finally Spikes Up and Back Down

The long-awaited spike move upward by VIX finally occurred this week. It was hardly the classic type seen at least three other times in the last year, but it was good enough it seems. VIX rose above 30 intraday on Tuesday July 15th and then fell back sharply after that. That is typical action at a market bottom, and indeed the S&P500^® Index (SPX^SM) has rallied strongly since then.

Does this denote the bottom for the market? It is too early to say, but at this point, VIX has not dropped enough to classify its action as that of an intermediate-term trading bottom. For that designation to be applied, VIX would have to break its uptrend, which would mean it would have to close below 23 or so.

See Figure 1 for a chart of VIX, noting the temerity of the current spike as compared to the previous ones. The current VIX peak is most like the one in November, which led to an S&P 500 Index rally of 120 points, but was just a bear market rally as lower prices soon followed. Also, note the rising trend line drawn on the chart. If this trend line is not broken, then lower prices are to be expected for the S&P 500 Index. If it is broken then it's possible that strong rally of the type seen in February or April will be setting up in the near future.

Figure 1 Source: McMillan Analysis Corp.

Right near the bottom of the S&P 500 Index decline, VIX futures traded at a substantial discount, a well-known bullish signal. Specifically, Table 1 shows the (daily closing) discount of the August (front month) futures as the S&P 500 Index neared and then made its trading low this week.

The large discounts on three trading days, July 11th through July 15th, are shown in the table, and then the large market rally started the next day. The discount has now shrunk considerably, once the market rallied, to levels that are negligible as far as predictive value.

Once again this shows that it pays to monitor the premium or discount of the front-month VIX futures as they are useful in helping predict the S&P 500 Index market direction. In previous issues, we have noted that VIX futures traded at a premium to VIX for quite some time in April and May, an action which was the harbinger of the large market decline that's taken place since mid-May.

The Term Structure of Futures Prices

The relationship between futures prices is called the term structure. In general, if near-term contracts are more expensive than longer-term contracts and that relationship is widening, that is bearish. If the differential is shrinking, that's bullish. The typical bearish relationship developed as the market collapsed in recent weeks, and it has moderated somewhat with this rally. What is interesting is that the term structure still has a somewhat bearish shape, even after this market rally. The curve of the term structure is not as steep as it was, but it is still rather steep.

The current shape of the term structure is shown in Table 2. Note that VIX is highest, followed by August, then September, then October, and November. This is an upward sloping term structure. If it continues to flatten (i.e., the various futures converge in price), then that would be bullish. So far, that has happened only modestly.

July 8, 2008
Oil, the Dollar and Comparative Advantage
By John Tamny

Thanks to oil prices that have reached record levels, proponents of increased exploration in the United States have gained an upper hand in the debate over whether to drill in previously untapped areas. While it would be hard to argue against more robust exploration in the States, it should be said that some of its adherents ignore the dollar's outsized impact on the price of oil, along with basic economic laws regarding comparative advantage and trade.

Much has been made of expensive oil in recent years, while much less has been said about oil being expensive due to the dollar being weak. The oil discussion has for the most part centered on supply, but the simple truth is that since June of 2001 oil has risen 160 percent in euros versus 376 percent in dollars.

The above number is important in many ways, but most notably it's a reminder that even if future oil discoveries make the U.S. energy "independent," U.S. consumers still won't be free of monetary mistakes that make gasoline dear. Indeed, owing to discoveries in the North Sea in the mid-'70s England was effectively energy independent, but this in no way shielded its citizenry from dollar and pound debasement that made fuel very expensive.

Furthermore, the law of comparative advantage states very clearly that as economic actors all, we should let others labor to make for us what doesn't maximize our profitable talents so that we have time to pursue work that does.

Thanks to trade over the years that's mostly been free, Americans have long done just that. While we could surely be "independent" when it comes to producing clothes, televisions and cars, we've often allowed foreigners to make those products so that we would have time to build the Googles and Microsofts of the world. A better, more enriching deal in terms of trade would be hard to fathom.

When oil is considered, the simple wonders of comparative advantage have seemingly been ignored of late. Many politicians and commentators excitedly point to the economic nirvana that would surely result from a robust national energy policy. Thanks to increased exploration stateside, good jobs would be created in the oil space that would bless us twice for domestic petroleum purchases driving down our alleged trade deficit. On its face this sounds good, but basic economics suggests this would be an economic retardant.

Indeed, what's been forgotten is that even in good times, the oil business is not a very good one. While oil companies presently enjoy returns of 8.3 cents in gross profit per dollar of sales, firms in the electronics and computer equipment sectors respectively make 14.5 cents and 13.7 cents per dollar. Former anti-trust miscreant Microsoft earns 27.5 cents per dollar of sales. In short, even if the rules regarding drilling were liberalized, it's hard to imagine many Americans deserting the cushier margins earned in other industries for the relatively mundane returns offered from oil exploration.

Instead, it could credibly be said that we have an even better deal at present whereby we send weakened dollars overseas in return for oil. Some say this enervates our wealth position, but more realistically it enriches us. With all dollars eventually returning to these shores, the money we spend on a product offering low margins frequently comes back as investment in even higher-value ventures.

This isn't to say that the unexciting returns earned in the oil sector should make the political class rethink whether enhanced exploration rights are wise. More drilling would be a positive. On the other hand, average returns in the energy sector are a certain reminder that liberalized drilling rights should include the right for foreign oil companies to bid for drilling access alongside our own oil companies. Let market forces prevail here, but be sure to let those not American into the tent.

Doing so would insure that just as we seek to apply comparative advantage to most other economic activity, so will we when it comes to oil exploration. If we ignore these economic realities, American human capital will be wasted on less profitable activities that will retard our economic advancement.

Some will naturally say that allowing foreigners to drill on our lands would be to this miss the point, that enhanced exploration should only benefit Americans. Forgotten there is the basic truth that it doesn't matter where oil is discovered.

Whether oil is found in the Middle East, Canada or Alaska is immaterial. It's only wealth if it's sold, and once the oil reaches the marketplace there's no accounting for its final destination. Americans will bid for oil alongside the rest of the world, and even if future discoveries make us "independent," our demand will occur in concert with worldwide demand on the way to a world price.

To engage in talk about where oil originates is to make a distinction without a difference. And to implement a singularly American energy policy run by Americans would be to ignore simple economics on the way to sub-optimal use of what is limited human capital.

John Tamny is editor of RealClearMarkets and a senior economist with H.C. Wainwright Economics and Toreador Research and Trading. He can be reached at jtamny@realclearmarkets.com.

About CBOE Futures Exchange

CBOE Futures Exchange (CFE^®) is an all-electronic open access exchange, which utilizes the CBOE’s^® state-of-the-art trading system, CBOEdirect^®. CFE is the leader in providing innovative volatility risk management futures products, including VIX^® and variance futures, which enable market participants to manage volatility risk, as well as trade volatility directly. Access to CFE is available through numerous brokers, ISVs or directly via the CBOEdirect API or CBOE’s HyTS^® terminals. CFE trades are cleared by the AAA-rated Options Clearing Corporation (OCC). To contact the CFE, please click here.

About Larry McMillan and McMillan Analysis Corporation

Professional trader Lawrence G. McMillan is perhaps best known as the author of Options As a Strategic Investment, the best-selling work on stock and index options strategies, which has sold over 200,000 copies. An active trader of his own account, he also manages option-oriented accounts for certain individuals and in addition, he is the Portfolio Manager of The Hardel Volatility Arbitrage Fund (a hedge fund). In a research capacity, he edits and contributes to his firm’s publications: Daily Volume Alerts, The Option Strategist and The Daily Strategist—derivative products newsletters covering equity, index, and futures options. Finally, he speaks on option strategies at many seminars and colloquia in the United States, Canada, and Europe. He is quoted in publications such as The Wall Street Journal, Barron’s, Technical Analysis of Stocks and Commodities, Data Broadcasting’s Exchange magazine, Futures Magazine, theStreet.com, and Active Trader Magazine. In these capacities, he is the President of McMillan Analysis Corporation, which he founded in 1991. Prior to founding his own firm, Mr. McMillan was a proprietary trader at two major brokerage firms—primarily Thomson McKinnon Securities, where he ran the Equity Arbitrage Department for nine years.

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The information in this newsletter is provided solely for general education and information purposes and therefore should not be considered complete, precise, or current. Many of the matters discussed are subject to detailed rules, regulations, and statutory provisions that should be referred to for additional detail and are subject to changes that may not be reflected in this newsletter. The strategy discussions contained in this newsletter are designed to assist individuals in learning how volatility and variance futures as well as other volatility-based derivatives work and understanding various volatility derivatives strategies. The strategies discussed are for educational and illustrative purposes only and should be not be construed as a recommendation to buy or sell a security or futures contract or to provide investment advice. Additionally, commissions and other transaction costs have not been included in the example strategies and will impact the outcome of security and futures transactions and must be considered prior to entering into any transactions. Investors considering volatility-based derivatives should consult a professional tax advisor as to how taxes affect the outcome of contemplated transactions in volatility-based derivatives. The charts and/or graphs contained herein are intended for reference purposes only. Past performance is not indicative of future results.

The views of third party contributors to this newsletter are their own and do not necessarily represent the views of CFE or its affiliates. Third party contributors are not affiliated with CFE. This newsletter should not be construed as an endorsement or an indication by CFE of the value of any third party product or service described in this newsletter.

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