Don Fishback

Statistical and Implied Correlation: Sector ETFs

Actually, Mathematica is overkill, at least for this. I just use Excel.

Some Thoughts on Leveraged ETFs

Hey kfisher ...,

I couldn't agree more with the improper use of the one-year chart. Just don't reach out and shake me. The *only* reason I show a current, real world chart is to point out the contrast with the *hypothetical* one-year chart that's in the prospectus. Look at their chart and you'll see that it implies near perfect tracking over the course of ... ONE YEAR!

And to your point that these things *do* work as advertised "if your timing is perfect*. I agree. But if you're timing is not perfect, then you cannot expect the fund to perform as the charts in the prospectus indicate. Instead, they'll perform as the Bloomberg chart indicates.

So don't get mad at me for having a one-year chart. ProShares is the one with the one-year simulation chart in the prospectus. I'm just showing people how these things operated in the real world, as opposed to the pretend world.

Actual Sector Correlation Reaches New High

For certain types of option trades, it's very good. For others, not so much. It's really more of an indication of market participation and dispersion.

Banks Not Letting Owners of Foreclosed Homes Walk Away

Not using my brain? That's classy. Did you actually take the time to read the article in the Milwaukee paper that is linked to in the blog post? If you had, you would have read THIS:

"Case in point: the vacant, boarded-up two-story house at 2721 N. 26th St., which for years had been owned and rented out by Rosella Chambers.

"In 2006, Chambers refinanced the 100-year-old frame house for the second time in four years. She received a $68,800 adjustable-rate mortgage through BWM Mortgage, a now-defunct Wauwatosa mortgage banker. The loan was for nearly $30,000 more than the property's assessed value.

"On May 20, 2008, Minneapolis-based U.S. Bank sued her for foreclosure. The bank had no interest in the mortgage - it was merely the trustee for an investor group that owned the mortgage. U.S. Bank had been instructed to sue by Pennsylvania-based GMAC Financial Services, which serviced the mortgage for the investor group. GMAC services about 2.7 million mortgages with a balance of $386.3 billion.

"A foreclosure judgment was issued in Milwaukee County Circuit Court in August but vacated, at the lender's request, on Oct. 22 - less than two weeks after Chambers died following a long illness.

"Chambers' daughter, Dianna Myles, said she was offered the property but did not want it. Myles said the house needed work even while her mother was alive, and since her death it had been stripped of all valuables and vandalized.

"The city boarded up the house this year and began its own foreclosure proceedings for back taxes."

...

"Loan-servicing companies argue they have a fiduciary duty to the investors who bought the mortgage, not to the neighborhood where the home is located."

"We do the cost-benefit analysis (for) the investor," said Jeannine Bruin, GMAC's executive director of mortgage communication. "Is he going to recoup any money for us to go through the whole process of foreclosing, fixing the property up, marketing it, selling it? Is anything coming back to that investor? If not, it's best to just let the borrower keep ownership of the home."

Got that SoCalGal? The lender does not take possession of the collateral. GMAC is not finalizing the foreclosure, thus letting the borrower keep ownership.

Now, is this story true? Is this the final chapter of the story? Is the city going to go after the bank anyway? I have no idea. I just know this, things have gotten so bad in certain areas that if the borrower thought they walked away, they actally may have not, at least as far as the city and the lender are concerned. In fact it's the lender that walks away, leaving the ownership of record as the person who actually bought the house.

Should be an interesting legal battle as to who eventually ends up getting stuck with the bill. As Gregman2 states, the banks may have no choice. But in this situation, these lenders think that the house, and all of the obligations that come with it, are the responsibility of the homeowner/borrower.


On Jul 13 11:16 AM SoCalGal wrote:

> I think that Don Fishback isn't using all the brains God gave him.
> If the homeowner stops making the mortgage payment, and the bank
> won't take the property back, the bank would have to put a gun to
> the homeowner's head to enforce payment of property taxes. As far
> as upkeep, if I was the homeowner, I'd pay upkeep all day long to
> be able to live in the property payment- and property tax-free.
> The bank gets a property that is properly maintained by the homeowner
> while the bank deals with its collateral and the homeowner has a
> relatively cheap place to live.
>
> What a country!

Banks Not Letting Owners of Foreclosed Homes Walk Away

Hey folks, seems I struck a nerve with a couple of you. I'm not saying anything about this being right/wrong, smart/dumb. I'm just saying it's actually happening, and I linked to the article where it has happened. Think about it this way, the recourse the banks have for non-payment of the mortgage is to take possession of the property. And while they may start the repo/foreclosure process, some banks are not completing it, leaving the homeowner -- the person that actually has possession of the property -- stuck with the property, and all the obligations that come with it.

As to je's statement that the banks are powerless to force the homeowner to keep possession of the house he or she bought, that's what's silly. If you have collateral against a loan you've made, you don't HAVE to take possession of the collateral. You can easily sit back and bide your time.

As to me reconsidering the point of the article, here is my point. I never thought I'd see something like this: banks starting the foreclosure process, then realizing that foreclosing on some properties would actually be a such a bad business decision that they let the homebuyer keep the property. That's how bad things have gotten.

Best Time Ever to Trade Options Leads to...Lower Volume?

Seeking Alpha editors removed the last paragraph of my original blog post that discussed DEEP in the money covered calls. That's a key omission.

For instance, ANTS correctly brings up the issue of downside risk causing the loss of capital. But here's a for instance why I like those deep ITM covered calls. I did a trades on MBT, AXP and BK. In each instance, the stocks FELL more than 20% after I implemented the trades. But here's the key, in each instance, the breakeven prices of the covered calls were more than 30% below the then-current stock prices. So in each case, I made profits. And those profits were not small. In each case the profit potential exceeded 20% return. Not annualized return. Straight up one month returns.

The point is, I agree that the risk of large downside is high. But with the deep ITM covered calls (which is what the last paragraph discussed), you can withstand that kind of catastrophic fall.

I wish that last paragraph had not been deleted!

Beware Potential New VIX Products

Hey Stephen, what you just said about being honest with one's level of sophistication could not be any more perfectly said. If you're not honest with yourself, you'll get destroyed. Maybe not immediately, but eventually.

As far as an alternative volatility play, isn't that the key question?

Here's the unfortunate answer. There is none, at least none that is easily accessible to the retail trader. Want proof. Think about this: If there was a pure play on volatility, don't you think they'd have launched that product by now? Instead, they're launching a product based on the futures. The reason is pretty simple. A product designed to be a pure play on volatility is almost impossible to create. Otherwise, don't you think someone would be offering it by now ... especially right now!!

I'll just tell you what I do. When volatility is this high, I sell in-the-money covered calls, out-of-the-money naked puts (secured by cash) and credit spreads.

-- Don

Proposed VIX ETNS Are Not a Volatility Bet

Thanks for the comments.

To vix switch trader, you're sort of right about that convergence. Convergence happens. In fact it's a must. [Well sort of. You should see how they calculate the settlement values.] But to say "December was priced lower than spot when it was a back month" is not correct. Notice in the top row of the table that when VIX was 17.83, the December futures were nearly 5.00 points higher at 22.72.

As I said in prior posts, the futures tend to have a greater central tendency than the VIX index itself. As you get closer to expiration, correlations go up and you eventually get the convergence you spoke of. But not always.

What is unusual is the *size* of the departure from spot that occurred in October. As the table above shows, at the end of June, July, August, and even as recently as September 10, the difference between VIX and its futures were mere pennies. But after Lehman's bankruptcy, the difference in the futures and the "spot" went haywire, which would have caused the ETNs to go haywire compared to what most people would have expected.

And that's the key. When VIX makes an extreme move -- up or down -- the normal relationship between VIX and the futures breaks down. At the precise time you want profit from an extreme -- either via a hedge or a speculative position -- the product behaves differently than it normally does.

Why that happens is the lack of arbitrage. The VIX futures and VIX itself are extremely difficult to arbitrage. As I hear it, only Susquehanna even tries. There is a formula for the VIX futures' fair value. It's actually not too difficult, but it is extraordinarily tedious. At any rate, you can still figure out what the fair value should be and then compare that to the VIX futures. This process is extremely common with S&P 500 index futures. The thing about VIX futures is that, unlike other index futures, the difference between fair value and the price can get extremely large for extended periods of time due to the inability to arbitrage.

And if you want evidence as to the ease/difficulty of the arbitrage play, think of this. If it was easy to replicate VIX itself, why not launch an ETF that mimicked VIX instead of the futures? How popular do you think THAT would be? I know I'd find it tempting. But there are zero plans to launch a product like that, because nobody can create a portfolio of tradeable securities that consistently replicates VIX itself. If they could, they would ... and then they'd easily arbitrage the futures divergence. The implications of this are: The divergences that exist for weeks at a time are proof that arbitrage doesn't exist in any meaningful size.

Now it is true that the ETN's prospectus mentions arbitrage. But it's important to realize they're talking about the arbitrage between the ETN and the futures contracts, not the ETN and the VIX itself.

One final thing, and this is important regarding convergence. Because these products are perpetual, they may never converge. Unlike futures which have an expiration date and therefore *must* converge to spot, these ETNs represent a "rolling" 30-day futures contract, so there is no guarantee of convergence at expiration, because there is no expiration.

As for the other questions you ask, I simply don't have the answer. And I have to say, I don't want to take the time to investigate until these things prove more valuable than I think they'll be.

-- Don

Beware Potential New VIX Products

Hey ETF Expert, Don here.

Thanks for commenting. Before I answer your questions, I have a couple of questions back to you.

You talk about a 95% correlation between the ETN and the item it is tracking. My question is, "What do you think the item is that ETN actually tracks?"

My second question comes from your question that asks, "What would you suggest as a replacement for a volatility play?" Here's my question, "Do you actually think that the new VIX ETN will always represent a volatility play?"

Look forward to hearing your responses.

And as far as waiting and seeing how it performs, they've already posted the backtested data and disclosed the target benchmark, so we can make a preliminary assessment now.

One a completely different subject besides correlations, benchmarks and tracking, one easy assessment is that if you trade these ETNs, you're an unsecured creditor of Barclays!! Do you want your volatility bet to be dependent on the creditworthiness of a teetering bank?

-- Don

Insuring U.S. Government Debt: A Terrific Paradox

Just saw this for anyone interested. Paul Kedrosky and Felix Salmon are going to have a live chat on this subject on Monday at 9 a.m. PT.

Here's link to the article at Paul's web site:
paul.kedrosky.com/arch...

Insuring U.S. Government Debt: A Terrific Paradox

Felix noted this in his article, and User 339138 states it in point (3). As donselion noted, this is really similar to an option. But it's an option that I don't think anyone can reasonably expect to exercise. It's not like a call option on a stock where you can exercise it and get the shares. In this event, the option can only be exercised if the U.S. defaults on its debt, which, because of the intertwined nature of our global financial system, would have catastrophic consequences everywhere. So, I think people are just trading this, hoping and praying that someone else comes along to buy the CDS contract at a higher price later.

Insuring U.S. Government Debt: A Terrific Paradox

Alan, You make a valid point that the event could be perceived as trivial. But as I understand it, and I am not an expert on the specifics of the particular contracts being measured by Markit, these credit DEFAULT swaps are specific to a default-type event. A downgrade would merely require more collateral from the swap seller. And the bank holiday and insolvency of the FDIC would not impact the bonds that are being insured, unless those events are in conjunction with defaults on U.S. Treasury bonds.

I have searched for clarity as to what could cause a triggering event. As yet, I haven't found anything. So I am just going by the standard definition of what, in the past, have constituted as triggers, such as failure to pay, restructuring, bankruptcy and moratoriums.

-- Don

Taxes: So Complicated, Even the Folks in Charge Can't Get It Right

Yeah, after I posted this, more info has come out. It certainly makes it seem that he knew what he was doing. Especially the part where he first only paid what they could get because the earliest years had gone past their statute of limitations, so the IRS couldn't get him. Then, when Obama's folks came calling, he paid his true obligations in full (even though no law required him to do so).

Taxes: So Complicated, Even the Folks in Charge Can't Get It Right

Don here -- Just to be clear. I tried to write this without rendering judgment as to these two guys' motivations. I'll admit that the only explanation is one of two things, both of which are indictments. Either they're cheats, or the tax code is too complex. Take your pick.

Measure, Don't Model: The Forest and the Trees

CM, Glad you wrote back. Seriously. And I do appreciate the information in the comments.

Here's my take on this. The entire modeling thing to me is great for estimation of probabilities of asset classes, not individual assets like stocks. And like I said, estimation only. That's it. When someone tries to be too precise, they're asking for it. You cited drift. I tend to ignore drift because it's offset by the interest rate discount that you should apply. That's not that I don't know those two factors exist. It's just that if you're going to be precise, why not go all the way? Or better, you can simply recognize that in most trading instances, it's not significant. It would be significant if you were valuing derivatives whose duration was in years. But the VIX is just a 30-day read. There’s simply no need to make things complex when something simple tells you everything you need to know. Similarly, I could have raised a stink about the Bloomberg article's use of a linear distribution instead of a logarithmic distribution. But again, over a 30-day period, it's insignificant. So I made an adjustment and omitted logarithms from the equation I posted. But that still misses the bigger point, which is no matter what adjustments you make, a model is still just an estimate!!

My point remains that there were bigger picture issues than nitpicking over drift, logarithms and interest rate discounting. I thought that introducing a new tool that let's you easily visualize the bell curve probabilities versus the real world probabilities, and making sure that my assumptions matched those used in the Bloomberg article, was more significant than getting the trivial stuff. But like I said, I can modify it to include drift. It's not that hard. Maybe I'll make a special copy for you. And I don't mean that in jest. Who knows, maybe you'll like it and endorse it.

I do want to clear up something before I go back to work though. Do you really think that I believe that betting on stagnation always works? You keep saying that it works till it doesn't. I never said otherwise. In fact, I began my prior article by saying that the market makes far more 3, 4 and 5 standard deviation moves than expected. And I'm the one who gave the example of the catastrophic biotech situation. All I ever said, with respect to stagnation is that regarding one standard deviation moves specifically, in the S&P 500 specifically, over the past 18 years specifically, the bell curve assumptions misjudged the odds. I then provided readers a mechanism to test different standard deviations to see how different tails stacked up. That’s it. I am not a partner in Capital Decimation Partners, LLP.

Lastly, whether you meant to or not, you did raise my ire when you said I'm "falling into a trap" and "you are making some serious errors". Well, I'm not. Prior to that, we differed on drift. But then, out of the blue, you say I’m falling into some traps. I asked you to explain, and you said that actual probability distributions are just one of an infinite number of paths that a stock could take. That is true … But here’s what’s really important, at least to me -- I never said otherwise!

All I ever said is that the bell curve and the models based on it are wrong, and here’s a free tool that uses past historical price movements to prove it! For you to take the general premise of my articles, which by definition don’t include everything in my mind, and then say I’m perpetuating a myth, and then turn it into a lecture on me falling into a trap is condescending. And to go even further and say I am making some serious errors, when the error you cite is me combining the biotech example with the probability analysis tools on my web site, and somehow concluding that based on a bunch of numbers, I believe that the improbable becomes impossible—which I never did—is, well, that’s just wrong. Because I never said it, wrote it, or thought it!

I could go on and on, and qualify my remarks even further. But I’ve got a cold one on my desk and not in my hand, and it’s begging to be consumed. Plus, I’m sure this thread is boring to everyone else. And, I don’t want to give away all my secrets!!!

But more important. I don’t think you and I disagree on anything consequential. I just ask, be aware of your words. Saying I’m perpetuating a myth, falling into a trap and making serious errors are inflammatory, just isn’t necessary.

Stay in touch.

-- Don