Wednesday, November 26, 2008


I have previously discussed using the VIX as an integral part of an asset allocation model. These posts are scattered but here is a link to some of them:

The discussions occur throughout my posts with some of the more detailed discussions made during some of the more recent posts. One area that is a work in progress is what to sell during a forced reduction in stocks generated by the model.  My approach last year was somewhat haphazard since this is a new model for me.  My first thought was to eliminate high beta stocks, to reduce reduce exposure to emerging markets to almost nil, and to sell non-dividend paying small cap stocks (one of my favorite asset classes).   Since we have a volatility index linked to the Russell 2000, RVX, I could look to that index for confirmation of trouble for small caps.   I would like to have volatility indexes for all asset classes to help me with this allocation.  My model for the RVX is more complicated but it did confirm my decision to include small caps in the forced liquidation.  Next time, I will include all closed end investment funds since the discount to NAV rises considerably when individuals are under stress caused by a bear market, and even now discounts of over 20% are widespread.  Why does this make a difference?  You suffer a double whammy, a fall caused by the bear market plus a widening of the discount from around 10% to 25% or higher.  Some discounts reached 40% during periods of maximum stress. Needless to say, any leverage would need to be eliminated and that would include leveraged funds that use borrowed money to enhance returns.  Leverage will only accelerate the down move (the more you own, the worse it is)  Another rule that I follow after the forced reduction is that common stock buys can only be made from the proceeds of a sale or from cash flow generated by dividends or interest payments.  I would not deploy the cash raised from my VIX model's forced reduction until I receive a signal of the return of a stable VIX consistent with an investable bull market.    Another modification that I have made is to buy SDS as insurance when the VIX swings from the mid 30s back to 16 to 20, reinvest the dividends and this would be kept until a stable VIX pattern returns.  Dividends would be reinvested into shares.  That holding is separate from the SDS/SSO swing trade during an unstable VIX pattern which I have discussed.  Gold and Silver ETF buys are not controlled by the VIX model. I have traded OIL and UNG but this has been by the seat of my pants and the commodities are likewise not governed by the VIX model.  If a volatility index is developed similar to VIX for commodities, I might start to use it some.  Lastly, I am not a slave to my model.  The model is subject to change by a human being when circumstances warrant.  The most recent change had to do with the SSO/SDS SWING trade, which now requires a stop loss on the SSO part whenever the VIX goes over 40 for the more conservative trader or over 45 for the crazy ones.  The SDS part has been modified to allow 1/2 of a position to be placed in the unstable VIX pattern when the VIX first goes back under 20 after spiking to over 30 out of a stable bull pattern with the remainder placed at discretion of the trader but preferably below 18.   For the SDS held in the Swing Trade, then the sell can occur in increments too, at or close to a 30 VIX (possibly as low as 28) with the remainder on a spike day to 33 to 38 which is where the SSO would replace the SDS in the swing trade.  I also used TWM this year and SKF.    The later was just too wild for this old man when it started to move in 10 dollar a day increments to the upside.  TWM had a lot of movement too.  It is tough to stick with the double short trades but so far I am comfortable with my system with the modifications made in it and discussed above.  Now, I do not have a trade and the model would have me out of SSO when the VIX passed 40. Next time, I will keep at least 100 SDS for the duration of the unstable VIX pattern-as a form of insurance, which I did not do for this bear market.  Using the double shorts and double long ETFs appears to me, at least it does now, to be part of a viable strategy tied to the VIX models that I have developed.  This is not for the easily flummoxed and disturbed or for those without extensive experience. 

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