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  • Article Trading Volatility by D.R. Barton, Jr.
  • Trading Education Forex Workshop Added for June
  • Trading Tip Clearing a Path To Trading Success by Kevin J. Davey
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“Things are not always what they seem; the first appearance deceives many; the intelligence of a few perceives what has been carefully hidden.”—Phaedrus, Roman Fabulist

The trading and investing world seems insatiably hungry for trading baskets—baskets of different kinds of stuff. Groups of assets have been traded in closed-end funds (where no new shares are created) since the practice first appeared in 18th century Scandinavia. Almost two centuries later, open-ended funds (those that can issue new shares) started to appear in the 1920s. Mixed-asset funds including both stocks and bonds followed, and in the 1970s, the first true index-based fund appeared. Now there are literally thousands of mutual funds, Exchange Traded Funds and Exchange Traded Notes that trade the spectrum of financial products and the globe.

Why are there thousands of funds? Traders and investors tend to think that they can trade anything, and the financial industry has simply responded to that conviction. There are now funds for trading geographic regions, sub-regions and countries. Funds for sectors and industries. Funds for individual commodities and baskets of commodities. Funds to trade the bonds of different countries, with different maturities and different risk levels. There is a tradable fund for literally almost anything you can imagine.

Even with the development of so many kinds of funds, money managers have continued to look for ever more sophisticated ways to speculate and hedge. They longed to trade volatility, but there was no underlying asset to put into a fund because when you trade volatility, you basically trade a statistic, or more accurately, a forecast.

But innovative fund companies were hard at work on the task, and recently, volatility funds were born. In January of 2009, the iPath VIX Short Term Futures ETN (Symbol:VXX ) started to trade, and it has been an overwhelming success. VXX now averages about 50 million shares traded per day.

Currently, there are 30 stock volatility ETF products being traded. And while there is a definite allure to trading something that expands and contracts with the great regularity of volatility, there are also some flies in the ointment that everyone should be aware of before diving in.

Understanding Volatility Instruments–Like Grasping Oil in Your Hand

Over the years, I have written many articles about volatility and the market’s favorite way of measuring it—the CBOE Volatility Index (or VIX). The VIX represents a constant 30-day measure of the expected volatility for the S&P 500 Index. It uses the prices of out-of-the-money, near-term S&P 500 options to calculate this expected volatility and presents it as an annualized percent. Math geeks and others who are curious can dig into the details at the dedicated CBOE VIX site:

Here’s a question: How many US financial products directly trade the VIX? Interestingly, only one—the CBOE Volatility Index Futures (VIX options are contracts for VIX futures, not for the VIX Index itself). And since the underlying index is a calculated implied volatility forecast rather than a basket of actual goods, no arbitrage or carry trades are possible. That alone makes the VIX futures contract rather unique. But it only gets weirder from here.

A futures contract settles on a specific future date, so comparing the price of a VIX futures contract to the actual VIX index is a lesson in abstract reasoning. The short version goes something like this: The VIX index is a calculated forecast of volatility 30 days from now. VIX futures are an anticipatory forecast for a period that is different from that of the VIX Index (and always days, weeks or months further into the future). So VIX futures anticipate at what level the VIX should be at some future date. This means that there can be some serious discrepancies in the absolute values between the Index and the Futures contract. Let’s look at a chart of the current front month of Futures vs. the Index.

Lead Chart

We can see from the difference in relative price levels in October of last year that VIX futures traders anticipated that the market would not sustain the high VIX level for many months into the future. Conversely, the Futures contract now shows that traders expect the VIX to rise off of the 5-year low that it hit this past Friday.

More VIX Nuances

If that’s not convoluted enough, consider that the VIX futures (and options on those futures) are the only instruments available for fund companies to build Exchange Traded Funds and Exchange Traded Notes. So we basically have 30 different funds out there that use some combination of VIX futures contracts to vary their content. The short-term volatility funds use the close expiration months. Medium- and longer-term volatility funds use expirations that are further away, and inverse funds use short positions. But they’re basically all using the same instrument in different ways!

Here’s the kicker. Almost all traders watch the VIX index, but none of the tradable instruments track the VIX directly, or not even necessarily closely! These instruments often move in the same general direction as the VIX, but the magnitude of their moves is almost always different from the VIX itself. For an example of when the movement wasn’t even in the same direction, though, take a look at the price bars for the last two days in the chart above. The VIX index went up slightly on both days, while the particular futures contract dropped significantly, making new lows each day.

The bottom line is this: volatility’s regular cyclicality and its effective hedging properties make it very alluring as a tradable concept. Before you jump into trading volatility instruments, however, make sure that you fully understand the relationship between the instrument you’re trading and the underlying volatility indicators. Understanding how to trade the VIX will differ from the reality of trading any of the related instruments.

This is particularly true when strange upsets happen. Just fourteen months after its inception, one volatility fund (TVIX) became so popular that it was trading more than 20 million shares a day. Its rapid growth made keeping up with the risk management parameters increasingly more challenging for its issuer. When the issuer could no longer maintain those parameters, it halted the creation of new shares—essentially turning it into a closed-end fund. That action changed the very nature of the instrument, but many people unwittingly continue to trade this “volatility” fund thinking that it still tracks the VIX. It doesn't anymore.

We’ll dig more into the details of this unusual occurrence next week. Until then, a word to the wise: Be sure to avoid trading TVIX. It isn’t what you think! Caveat emptor.

I’d love to hear your thoughts and feedback. Just send an email to drbarton “at” Until next week…

Great Trading, D. R.

About the Author: A passion for the systematic approach to the markets and lifelong love of teaching and learning have propelled D.R. Barton, Jr. to the top of the investment and trading arena. He is a regularly featured guest on both Report on Business TV, and WTOP News Radio in Washington, D.C., and has been a guest on Bloomberg Radio. His articles have appeared on and Financial Advisor magazine. You may contact D.R. at "drbarton" at "".



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Trading TipK Davey

Finding My Path to Trading Success, Part 2

In the last newsletter, I discussed how, in early 2006, I was trying to figure out the next steps in my trading hobby/career. After taking Van's Investment Psychology Inventory Profile, I found that I needed to work on these areas:

  • My personal life interfered with my trading success.
  • I had a poor attitude toward trading.
  • I lacked sound knowledge of trading fundamentals.
  • I displayed poor intuition toward the market.

Luckily, Van's Peak Performance Course was set up to help address these deficiencies. Let’s look at each one in more detail.

My personal life interfered with my trading success: Of all my weak points, this one has been the hardest to overcome. My relatively high score in this area suggested that stress from my personal life was taking a toll on my trading success, and that I needed to take steps to reduce it. Back then, I was not only trying to work full-time and trade part-time, I was also adjusting to life as a new parent, which, as any parent knows, leads to increased stress. Until it was spelled out by Van's test, though, I never realized the impact that stress was having on my trading.

Volume Two of Van's Peak Performance Course, "How to Control Stress," included more tests and checklists to help pinpoint my sources of stress. After those sources were identified, I used some of the many techniques in the course to help bring my stress to a manageable level.

I had a poor attitude toward trading systems: Many years before, I’d earned an undergraduate degree in engineering and a master's in business administration, and, as it turns out, my training in these areas had led me to believe that the markets were an easy puzzle to solve. This belief caused me to take shortcuts and commit other errors when I developed my systems.

Volume Three of the Peak Performance Course, "How to Control Losing Attitudes," really assisted me in this regard. In retrospect, it is clear to me that I had believed that the market owed me wealth. Since the market "owed" me, I tended to take the easy way out (consciously and subconsciously) by cutting corners, cheating or using hindsight during the system development process. Clearly, this was a losing attitude, and exercises in this volume changed my whole perspective.

My new, improved perspective was that the market owed me nothing. I had to work, and work hard, to achieve success. I had to shed my sense of entitlement and assume that the market would only give up its secrets reluctantly.

When I adopted this new perspective, my whole system development process changed. Now, if a new trading system easily generates great results, I assume that I probably made some kind of error during the system development process. I employ techniques that let the market prove my trading strategies right rather than let it prove them wrong.

I lacked sound knowledge of trading fundamentals: This weakness surprised me the most. After 15 years of trading, I thought I was pretty adept. Once my knowledge of fundamentals was questioned, though, I decided to study Volume Five, "How To Make Sound Decisions," to improve my understanding. I discovered that I was substituting numbers, formulas and algorithms for sound trading judgment and analysis. For example, instead of really understanding technical studies like RSI, stochastics and %R, I was just combining them into a system and then optimizing the result. Of course, once I realized this fact, the solution was simple: only create strategies for situations in which I understand what is happening, and why.

I displayed poor intuition toward the markets: This revelation did not surprise me at all. In all other aspects of my life, I tended to be a logical, fact-based decision maker. Rarely, if ever, did I make a decision based on a hunch. That approach served me well in what was then my full-time career in the aerospace industry, allowing me to achieve an executive position at a fairly young age.

Yet, in the markets, I frequently took "hunch trades" early in my trading. Once my poor intuition was pointed out to me, I almost immediately ceased this activity. Not surprisingly, my results dramatically improved. Occasionally, though, I still fall victim to the desire to take a hunch trade, but recalling my poor intuitive abilities usually helps me nip the problem in the bud.

As you can imagine, learning and changing was not an overnight thing. In many of these areas, I still struggle to improve, but I have made tremendous progress.

Of course, the real question is, did addressing these weaknesses actually work?

The answer came in January 2012, when, after six years of working on my flaws, I took the Investment Psychology Inventory Profile test again. Van gives 11 detailed scores in his profile, along with three section scores, a composite score and an overall ranking, for a total of 16 individual scores.

When I compared the January 2012 results to the June 2006 results, I was just as shocked as I was the first time I took the test—but this time, it was a good shock!

Of the 16 scores, I improved in 13. I only did worse in one area, and in two of the areas, I was the same. The best improvement was in my overall ranking. Originally, I was in the 50th percentile. Now, I am in the 75th percentile, which means I scored better than 75% of the traders who took the test. According to the profile, I was on my way to becoming an elite trader.

Of course, you may be reading this and thinking, "Well, that’s all fine and good, but did this improvement in a psychological test score translate into actual trading results?"*

*Editor's note—Next week's newsletter will reveal the answer.

About the Author: Kevin Davey has been trading futures for over 20 years, the last four years full-time. He can be reached at his website or at kdavey "at"


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March 21, 2012 - Issue 569

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