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How to Create a Synthetic Instrument In MetaTrader 5

January 2, 2018 by Shaun Overton Leave a Comment

The last version of MetaTrader required offline charts for anyone that wanted to create a synthetic currency pair or instrument. Since MetaTrader 5 still does not allow for offline charts, the ability to create synthetic time frames isn’t possible using the charting time series.

The new build 1640 for MT5 introduces the ability to create synthetic instruments. I, for example, want to watch VIX Calendar Spreads. Instead of just using my indicator, I also would like to see a chart that helps me track the calendar spread.

VIX calendar spread

A synthetic instrument chart displaying VIX Calendar Spreads

Market Watch MT5

How To Create A Synthetic Instrument Chart

Right click on the Market Watch window (look to the image on the right). You’ll see Symbols appear in a dropdown menu. Click on it.

Alternatively, just push Ctrl + U on your keyboard.

Create Custom Symbol MT5

Now enter in the Synthetic Instrument name. The name can be anything that you choose with allowed characters.

The most important step is to enter in your formula. As you can see in the image below, mine is a symbol subtraction. The primary keywords that you’ll use are bid() and ask(). So, if you want the bid of EURUSD, for example, you type in bid(EURUSD).

Finally, make sure to set the number of digits in your instrument. Otherwise, your chart will show a large number of unwanted, extra decimals.

Filed Under: MetaTrader Tips Tagged With: metatrader, synthetic, synthetic currency, VIX

Does SKEW Predict VIX?

December 22, 2017 by Shaun Overton 4 Comments

SKEW should lead VIX, right? Traders get worried about a crash, which might anticipate volatility in the S&P 500.

SKEW is in green.
VIX is in blue.

If SKEW was a perfect predictor of VIX, then you’d expect the blue line to look like the green line with a small gap in between them.

skew against vix

The theory was that SKEW (in green) would pull up VI (in blue).

 

A quick scan of the chart shows that’s not the case. There are occasions where green spikes up followed by blue, but it intuitively feels to me like a case of cherry picking. Also, notice the largest blue spike around value 500. If SKEW lagged VIX of the other way around.

Just for the sake of being thorough, I measured the cross correlations of If SKEW and VIX using both my smoothed values and the unprocessed ones.

Here’s the cross correlation of the smoothed values.

Cross correlation of skew and vix

The cross correlation of smoothed SKEW and VIX

 

And here’s the cross correlation of the unsmoothed values.

Cross correlation of SKEW and VIX

If anything, the hypothesis is backwards. SKEW 18 days ahead of VIX has a -19% correlation. The correlation should be positive and > 40% to carry any substantial meaning. The weak correlation value and the fact that it’s negative that this idea is better tossed in the bin.

Click here to download the data used in this analysis. You’ll noticed that I first normalized the VIX and SKEW values to allow for easier visual comparisions. Because the data is extremely noisy, I applied a 7 day SMA to make visual comparisons easier.

The data used was from October 16, 2013 to December 21, 2017.

What is SKEW?

SKEW, which is another volatility index run by the CBOE, provides a measure of how worried traders are about tail risks.

Here’s the full description directly from the exchange:

The crash of October 1987 sensitized investors to the potential for stock market crashes and forever changed their view of S&P 500® returns. Investors now realize that S&P 500 tail risk – the risk of outlier returns two or more standard deviations below the mean – is significantly greater than under a lognormal distribution. The Cboe SKEW Index (“SKEW”) is an index derived from the price of S&P 500 tail risk. Similar to VIX®, the price of S&P 500 tail risk is calculated from the prices of S&P 500 out-of-the-money options.

SKEW typically ranges from 100 to 150. A SKEW value of 100 means that the perceived distribution of S&P 500 log-returns is normal, and the probability of outlier returns is therefore negligible. As SKEW rises above 100, the left tail of the S&P 500 distribution acquires more weight, and the probabilities of outlier returns become more significant. One can estimate these probabilities from the value of SKEW. Since an increase in perceived tail risk increases the relative demand for low strike puts, increases in SKEW also correspond to an overall steepening of the curve of implied volatilities, familiar to option traders as the “skew”.

What is VIX?

This is also taken directly from the exchange:

The Cboe Volatility Index® (VIX® Index) is considered by many to be the world’s premier barometer of equity market volatility. The VIX Index is based on real-time prices of options on the S&P 500® Index (SPX) and is designed to reflect investors’ consensus view of future (30-day) expected stock market volatility. The VIX Index is often referred to as the market’s “fear gauge”.

The VIX Index is the centerpiece of Cboe Global Markets’ volatility franchise, which includes volatility indexes on broad-based stock indexes, exchange traded funds, individual stocks, commodities and several strategy and performance based indexes, as well as tradable volatility contracts, such as VIX options and futures.

These revolutionary volatility products can offer investors effective ways to help manage risk, leverage volatility and diversify a portfolio.

Filed Under: Trading strategy ideas Tagged With: CBOE, skew, VIX

Have Your Algo Running like a Swiss Watch

January 11, 2016 by Lior Alkalay 6 Comments

Setting up a trading algo that works smoothly, like a well-oiled machine, is not a trivial endeavor. There are many, many parameters that you have to take into account.  It begins with the signals your algo is generating to the margins in your account, volatility, gains and, of course, risk. Certainly you’ve used our previous tips to build your algo and to draft your strategy. So how do you incorporate all those elements and optimize your algo for the greatest precision?

How do all the quants make their algos run smoothly like a Swiss watch? You have to treat your algo like a machine, built up with numerous mechanisms. Because of course, that’s what an algo really is. I like to call those mechanisms boxes. Now don’t despair if you think it all sounds a bit too complicated. By the time you reach this article’s conclusion you’ll have realized that it’s all quite simple and logical.

An Algo Made of Boxes

So what is the approach quants use that I like to call boxes? You divide your algo into separate mechanisms, or boxes, if you will. Each box will become a stand-alone mechanism that receives input data and generates an output. There will be one box that we can consider the brain; that box decides if it is a go/no go for the specific trade. The brain box gets all the inputs from all the other boxes.

Algo Boxes

Signal Box- The signal box scans prices and parameters, such as the moving average or any other condition you have written into it. Basically, these inputs are the rules of engagement you had early written for your algo. One simple rule could be, let’s say, 14 days moving average < 30 days moving average = signal to sell. Typically, this box will be running prices in several pairs.

In other words, its input data and its output would normally be three parameters; an entry signal, a recommended stop loss and a limit. Of course, once again, these inputs are according to the parameters you have already defined.

Risk Box- The risk box, as its name implies, is the box in charge of risk monitoring. This one is a bit more complicated. The risk box gets input from several sources. It gets the risk, i.e. stop loss required, from the signal box. Moreover, the risk box constantly reads your available margin.

Its output is a go/no go on each trade that exists, based on the parameters you entered. For example, how much you want to risk in total or the minimal available margin to be left in the account.

Let’s say you have a free margin of 11% and you set up a minimal margin of 10% in the risk box. The signal box will send output of an upcoming trade.

The risk box can calculate that the executed trade would take 2% from your remaining margin. You started with 11% so that would leave your free margin at 9%. Therefore, the output from your risk box will be a no go for this trade.

If you had had 13% free margin rather than the 11%, the output would be a go. Of course, there are many more options to program into this box but this is the simplest one.

Volatility Box- The volatility box might be the most complicated to program. However, volatility charting is something we covered fairly thoroughly in these articles – Volatility & Your Trade, The World of the VIX, Using VIX Alternatives. The box’s task is to chart market volatility and provide an output if volatility is about to change dramatically. A major change to volatility could, of course, warrant a change in your strategy.

Execution Box (aka the Brain Box)- Easily can be considered the most important box of all. This box is in charge of making the finally decision. It gets input from all the other boxes and decides if the trade should be opened or not. It also decides if a strategy needs to be changed.

For example, if the volatility box signals an upcoming surge in volatility the execution box may decide to close some trades. Or it could instruct the signal box to change into a secondary signal model suited to high volatility. There are many other ideas that you can program into it.

Algo

How Boxes Help You Win

All of those boxes can help you make your algo run more smoothly and efficiently. How? Quite simply because it lets you optimize your algo to a much higher level. It provides you with flexibility to easily adjust each mechanism. More importantly, it lets you monitor the inputs and outputs of each box and assess which needs fixing.

Algo Box: The Bottom-line

Of course, the partitioning into various boxes is not a new algo concept. It’s also not rigid; there’s no need to do it exactly as I did. If you’re intrigued by the Algo mechanism box concept and want to delve into it a bit farther you’re in luck. I highly recommend the book Inside the Black Box by Rishi K. Narang. I’ve found that it sheds a great deal of light on what some might construe as a complicated strategy.

And for those of you that are short of time? You can use this as a basic guide on how to make your algo run smoothly, without reinventing the wheel.

Filed Under: Trading strategy ideas Tagged With: algorithmic trading, execution, risk, VIX, volatilty

Using VIX Alternatives

June 18, 2015 by Lior Alkalay Leave a Comment

Implied volatility is, or at least should be, a key factor in every trading strategy. In the past two articles we learned how to use implied volatility through the highly watched VIX index. We also learned that the VIX is a great tool to gauge when a range is about to be broken. And especially as it relates to the FX market, it can suggest when momentum is about to accelerate. But what about as it pertains to, say, the Nasdaq 100 or commodities? Can, or maybe more accurately, should you use the VIX as a barometer for those as well?

It’s an Asset on to its Own

Naturally, because the VIX measures such a broad variety of stocks, it’s a great tool both on and off risk. Yet as can clearly be seen in the correlation chart below, the VIX can’t work all the time. The concept behind correlation is simple; whether positive or negative, there are instruments (S&P500, Gold, etc.) that can be compared. The key is that the instruments or assets must move either in tandem or its inverse and the closer to 1 (or -1), then the closer the correlation of their movement. Even a -0.3% means there is some degree of correlation between the instruments or assets.

But what if the correlation is 0%? That’s bad news! This means that, at that particular time, you are in a dead zone. At 0%, the assets are not moving in tandem but moving as if they are not related at all. In such cases, a “crude” indicator of risk on risk off such as the VIX simply can’t help you. If you trade in the mid to long term, eventually that correlation will come back. If you’re worried about the next two or three days or even a week, well, then you might be in trouble.

CorrelationSource: V-Lab

Alternatives to VIX

Not all assets are moving exactly in tandem and as I just explained sometimes the VIX is too “crude” for surgical precision and you need to find something more indicative for your specific trade. The possible solution? A designated VIX indicator for each asset class. The possible problem? Not all VIX indicators are made equal.

There are several VIX indicators, five of which are major, the others less so. First, of course, is the VIX on equities, then the VIX on commodities, and last the VIX on bonds. There is also a VIX on interest rates but that is likely less relevant to the average trader. And, of course, there are various VIX indicators on currencies, which you can learn more about through my past analyses on FX volatility.

When it comes to equities beyond the VIX (which measures implied volatility on the S&P500) there is the VXN, which measures the NASDAQ 100’s volatility, and the VXD, which measures volatility on the Dow Jones Industrial Average. If you regularly trade Apple, Amazon or Google then you’ll be happy to know that each has its own VIX (respectively, VXAPL, VXAZN and VXGOG). These VIX alternatives provide more precise timing of breakouts and fallouts for traders of other major indices or the big tech stock. As seen in the chart below, the VXAPL or Apple VIX is an accurate barometer for potential Apple breakouts.

Apple VIX

 

Source: Financial Times & CBOE

Implied Volatility with Commodities 

Implied volatility in equities, and to some extent in FX, is considered a contrarian strategy whereby implied volatility at record lows suggests volatility is about to soar higher and vice versa. In commodities, however, the strategy works somewhat differently. Implied volatility could be viewed more as an indicator of the force of inflows and outflows of Oil, Gold or Silver (each having its own corresponding VIX).

As seen in the GVZ index below, the trend on Gold volatility as compared to price suggests that as implied volatility slides, interest in the metal also falls. And, to the contrary, if the GVZ bottoms out that could point to a renewed interest in the metal. What it all boils down to is that while implied volatility in equities and FX is a contrarian index, in commodities, it’s a trending one.

Unlike equities and currencies, with commodities it’s not a case of zones, or of lows or highs of implied volatility; rather, it’s a case of trajectory. While implied volatility is a great timing tool in equities or FX (given its cyclical nature), with commodities implied volatility tends not to be as sensitive and lacks the smoothness of the others. The pros: The GVZ indicator can still be very useful when interest among investors is growing and can help figure out long term trends. The cons: It’s only good for the long term.

Gold VIXSource: CBOE

 

Filed Under: How does the forex market work? Tagged With: VIX

The World of the VIX

June 8, 2015 by Lior Alkalay 4 Comments

The VIX, or Volatility Index, is among the most watched indices in the world, certainly on the CBOE (Chicago Board of Exchange), with most traders checking it at least once a day. Unlike most indices, the VIX’s price is not comprised of stocks or bonds. What the VIX measures is volatility around the S&P500 index using options.

 Why Bother with the VIX?

As mentioned, the VIX measures the volatility around the S&P500 index, or more accurately, the implied volatility around the S&P500 index. You might wonder, “What’s the difference?” Implied volatility is expected volatility, and since in trading tomorrow is the present, that difference does matter. As an index, the VIX is relevant whether you are trading FX, commodities or equities, but it holds a special significance if you trade the S&P500. That’s because the S&P500 is the most tradable (and traded) index in the world with most major asset classes having some level of correlation to it.

When the VIX rises (i.e. becomes volatile), in most cases, it suggests investors are nervous, not just in equities, but across the board. That is why so many investors often refer to the VIX as the “fear index” (my personal favorite, by the way).

In fact, one of the most dominant trades since the 2008 financial crisis is what investors call risk on/risk off. That means markets are primarily trading based on broad risk appetite. For example, when risk appetite is high, riskier trades (such as long equity indices or short dollar) tend to benefit. Simply put, the VIX measures implied volatility over a wide array of stocks. Because implied volatility generally rises with risk, the VIX is seen as a good barometer of risk on/risk off sentiment. The VIX is an important gauge of the market’s mood, whether you plan to counter or go with a trend. As you can see below in the chart (courtesy of V-Lab), the S&P500’s implied volatility and the VIX move almost in tandem.

VIX Chart

VIX: Under the Hood

The VIX is basically composed of the premium that investors are willing to pay for both call and put options on the S&P500. The average expiry date for those options is approximately 30 days and that tends to be when implied volatility is most indicative. The higher that premium, the higher the VIX will be. If we were to link back to the risk on/risk off trade, if investors are worried that risk is on the rise (which causes implied volatility in the S&P500 to jump) then the VIX simultaneously rises. When investors are calm, implied volatility falls and the VIX is lower.

There have, of course, been days when the VIX was rising and market was in risk on mode (and vice versa), but those cases are generally rare. Naturally, as a trader, you must always be aware that anything can happen at any time.

When to Use the VIX?

Now, here is the tricky part of the VIX; the VIX is what is known as a contrarian indicator. That means it is more useful as an indication of a risk of a change rather than an indication of the current trend. Behaviorally, the VIX can be likened to an elastic material; it always tends to gravitate back to balance. When the VIX is at record highs it tends to move back lower. When it’s recovered and hits a fresh low then it tends to move higher. While it’s important to always keep track of the VIX, as seen below, the extreme levels can suggest if the market is in a risk on/risk off mode. When the VIX is at record highs, it might be time to trade on a risk on mode. Why? Because market jitters are likely to wane and therefore risk related trades (i.e. long AUD, EUR, GBP, SPX, etc.) might be the wisest trade. Naturally, the opposite also (generally) holds true.

VIX RangeSource: CBOE

VIX has Cousins

Among all of the indices that measure volatility, the VIX is the most important, especially given the S&P500’s correlation with nearly every asset class. But what happens when you want greater accuracy or more relevance to your current trade (e.g. Forex, commodities or other global Indices)? While the VIX may be the granddaddy of them all, there is a “family” of volatility indices linked to specific indices, asset classes and even to specific trades. For example, the OVX measures the implied volatility on Oil, while the EUVIX measures the implied volatility on the Euro. Can’t wait to meet the rest of the “family”?

Want to learn how to use other VIX indicators? Then stay tuned for my next article.

Filed Under: Trading strategy ideas Tagged With: EUVIX, implied volatility, OVX, VIX, volatility

Volatility & Your Trade

May 29, 2015 by Lior Alkalay 1 Comment

Picture this; you’re on the verge of opening a new trade. The indicators you’ve been patiently awaiting – averages crossing, RSI hitting 80, or whatever else – are finally moving into perfect alignment. You expel a huge sigh of relief and your order is engaged. But then, instead of the solid trend you were expecting to see, you get instead pretty much nothing. A market that is just barely muddling through. You’re dragged right into a stagnant market leaving you scratching your head and thinking, “what did I miss?”

It doesn’t make sense. You were diligent; you did your research and you calibrated your indicators and still you got nothing. No movement at all; just a range.  It’s frustrating beyond belief. And what about the times you set up that “great” stop loss that the market abruptly sliced right through. Does that scenario sound familiar? Sure. It happens to everybody.

So, what did you miss? In a word: Volatility.

The Wisdom of Derivatives

Of course, we all know about volatility; it’s the measurement of price fluctuations. Or more plainly, it’s how fast a price moves. It is volatility (or its absence) that entangles a pair within a range, often swiftly and mercilessly. And while the average spot trader may believe volatility comes at the market’s whim that is generally not the case.

In the spot market volatility may seem a force majeure, but in derivatives trading, volatility is the essence, especially with options. Generally, options trading is based on volatility and more specifically, on implied volatility. And implied volatility is the expected volatility as embodied in the price of the options.

Implied Volatility Made Simple

Before you begin to get stressed out, rest assured, this is not a lesson in options trading. Rather, it’s a lesson on how to predict volatility and use it in your trade. Implied volatility is the suggested volatility as extracted from the price of Put and Call options on a specific stock or currency pair. If you’ve no experience with options trading this might seem tricky. In fact, that couldn’t be farther from the truth. Thanks to volatility indicators we can measure implied volatility on various FX pairs.

The CBOE FX Volatility Index

The CBOE exchange, where many FX options are traded, is also where you’d find a convenient series of volatility indicators. For example, the EUVIX measures implied volatility on the Euro, the JYVIX does the same for the Yen, etc. Reading an index is simple; when the index is high, volatility is expected to be high and vice versaImplied Volatility Source : CBOE

Two Dimensions to Watch

When analyzing the volatility index for a specific currency there are two dimensions to consider. The first dimension is pretty straightforward; it is the level of the index. If the level is high or rising then you should take that fact into account. That’s especially important if you’re planning to place a rather small stop loss. The EUVIX (and its ilk) can help you understand what level of volatility currently exists under current market conditions.

The second dimension denotes the “zones” of volatility. That is if the index hits a certain level or zone it tends to either fall back or bounce. In the graph above, note that the EUVIX tends to ease around the 13-14 zone and rise around the 11-12 zone. Unlike the spot market, with volatility indices it’s more of a zone you’re aiming for, not an exact spot.

EUVIX_upSource : CBOE

How would you use a volatility index?

It’s a straightforward process. When the index approaches or is above the zone of maximal volatility, you can expect volatility to fall. In that case, if you’re riding a trend, prepare for some slowdown in momentum. Conversely, if the index is below the area of minimal volatility, it’s likely that volatility will rise from here onwards. If the pair is range bound and you’re waiting for a break that could be good news. Bad news could also be good news if it triggers a stop loss close to the market price. What’s important is that you will be cognizant of where to expect volatility. Also, understand that the maximum and minimum volatility areas change over periods. That means you need to watch how the index responded in a similar timeframe (hourly, daily, weekly, etc).  Of course, as well all know, nothing in this world is a certainty, least of all in the world of trading. Even so, monitoring volatility, both in the long term and short, is crucial for trading success.

netjpy

 

Filed Under: Trading strategy ideas Tagged With: EUVIX, implied volatility, JYVIX, VIX

Trading Volatility: A Basic VXX Strategy

December 12, 2013 by Andrew Selby Leave a Comment

The continually evolving ETF and ETN marketplace has made it incredibly easy for the average retail trader to have access to plenty of different markets that used to be reserved for professional traders. With that new availability has come a large influx of strategies and ideas for quantitative approaches to these markets.

The creation of the VXX ETN has provided retail traders the ability to trade market volatility. Traders who used to simply use the VIX as a general market indicator are now able to actually trade that indicator.

trading volatility

The VXX makes trading volatility an option for retail traders. Jay Wolberg gives us a unique idea for a trading strategy.

Jay Wolberg from Trading Volatility published a strategy for trading the VXX based on signals from the VXX Weekly Roll Yield (WRY) and its 10-day simple moving average.

The rules for this idea are extremely simple:

There are two “halves” of this trading strategy:

1) being short VXX/UVXY (or long XIV/SVXY) whenever the WRY is below its moving average, and

2) being long VXX/UVXY (or short XIV) whenever the WRY is above its moving average.

He provides us with his backtesting parameters:

I’ve backtested the strategies separately for “short VXX only” and “long VXX only” from the inception of VXX (1/30/2009) through 12/10/2013.

Decision points are made using the day’s closing data (individual trades in the analysis can be viewed here).

Jay’s short side returns look very promising:

For short VXX only:

  • # of Gains: 59
  • # of Losses: 47
  • Avg Return: +4.1%
  • Max Gain: +40.4%
  • Max Loss: -19.2%
  • Sum of Gains & Losses: +438.6%

But his long side returns aren’t profitable:

For long VXX only:

  • # of Gains: 32
  • # of Losses: 74
  • Avg Return: -0.8%
  • Max Gain: +60.6%
  • Max Loss: -17.4%
  • Sum of Gains & Losses: -81.9%

As you can see, the short side of this strategy appears to have an edge, but the long side doesn’t quite stack up. Jay continues by providing histograms that report the returns of individual trades.

He also suggests that many of the long side trades started out profitable, but then gave back their gains and turned into slight losses. His theory is that implementing a trailing stop would have protected those profits and rendered a successful long side strategy.

In addition to adding trailing stops, I would also be curious to see how adding a long term trend filter would impact the returns. I wonder how many of his losing trades took place on the wrong side of the 100 or 200-day simple moving average.

Once again, we have a strategy that could be developed into something unique and profitable. However, at this point it is basically just an interesting idea.

Filed Under: Test your concepts historically, Trading strategy ideas Tagged With: trading volatility, VIX, VXX, weekly roll yield

SPY Crisis Strategy

October 11, 2013 by Shaun Overton 3 Comments

Yesterday’s musings on an S&P 500 doji strategy led to a general discussion of stocks and market crises. I promised to analyze a price-moving average cross strategy and to analyze the performance in times of exceptional volatility.

The results are in and they’re exactly what I predicted. I’m shamelessly tooting my own horn on this one – it’s so rare where strategies do exactly what I predicts.

SPY Crisis Strategy Returns

The direction of the returns matches any traders definition of crisis and regular trading periods over the past decade

SPY Crisis Strategy Rules

The trading rules only initiate short trades. No long positions are allowed.

Enter short next bar at market when:
The price crossed and closed below the 20 day SMA on the last closed bar
The trader believes that a crisis environment either currently exists or is about to exist

Exit an open short trade when:
The price crosses and closes above the 20 day SMA on the last closed bar

The position size is equal to a fixed dollar value divided by the current share price. As an example, SPY currently trades at $169.24. If you wanted to control a position size worth $1,000, then the number of shares is the floor of $1,000/$169.24 = 5 shares.

This strategy is intended to be timely for the current trading environment. Based on all of my proposed definitions below, most of the crisis alarm bells are ringing at the moment.

Defining a crisis

The most difficult part of this type of strategy comes from defining a “crisis environment” quantitatively. Crises don’t happen very often by definition, so I don’t think it’s a worthwhile endeavor to try to quantity the crisis bit. That said, a few obvious crisis indicators come to mind based on basic market mechanics.

PE Ratio

The morons on Tout TV (CNBC and company) keep on screaming how cheap stocks are. I’m not a fundamental trader, but the PE ratio contains useful information. Even the most hard core technical analysis buff would agree that companies generating huge positive cash flow and earning growth have to appreciate at some point. The argument isn’t about if that type of stock will rise; it’s just a question of when.

I don’t see how anyone could possibly look at the current PE ratio of 19.3 and argue that stocks are cheap. They aren’t. Stocks are currently very expensive based on a historical comparison.

VIX

VIX is a CBOE benchmark index that allows traders to compare the price of front month options traded on the S&P 500. A more detailed explanation of the VIX is available on Wikipedia if the concept is new. There’s nothing magical about the 20 level. It’s my general experience that most traders consider that number the one to watch. They think of VIX < 20 as "normal" and VIX > 20 as a severe market move.

VIX danger level

Most traders regard a VIX above 20 as a dangerous level.

Put-Call Ratio

Options are effectively leveraged bets on market movements with fixed downside risk. When traders load up on puts, they’re expecting the market to fall. When traders buy more calls, they’re expecting the market to rise.

The put call ratio is simply the number of put contracts traded / the number of call contracts traded. A number > 1 means that more puts were purchased that day than calls, indicating an expectation of a market drop.

Theory has it that short term traders are wrong, making the put call ratio a contrarian indicator. I see the put call ratio as more of a lagging indicator.

ES Put call ratio

When a move is real and already happened, traders react too late and buy protection that they no longer need. The 2008 financial crisis a great example when the ratio spiked to 1.5, a wild number. Just in the past week the ratio went as high as 1.3 before settling back down. The volatility in the number indicates a panicky crowd in my opinion.

Margin debt

Leverage is a two way sword. The theory is that it’s a way to multiply returns by risking debt in the market.

Most traders, and especially retail traders, wind up using leverage as the rope to hang themselves with. Stocks are most commonly purchased with cash among investors. Unlike forex and futures where almost every trader enters a position with leverage, the average retail stock trader enters a position using only the cash present in his account.

An increased willingness among traders to move from cash to margin debt is typically a sign of froth, bubble fever or whatever you want to call it. The chart of margin debt from Business Insider and Zero Hedge show that stocks are currently trading near historical highs.

margin debt business insider

Margin debt Zero Hedge

Conclusion

The 20 day SMA price cross strategy is a great way to run account protection whenever market warning signs are going off. The warning signs may not predict the precise market turning point, but the strategy can function as an effective form of insurance.

The strategy would roughly break even over time if someone were foolish enough to run it that way. Say that you mistime the crisis. Big deal. This type of strategy can run for months without causing irreparable harm to the account.

The signals can run in the background. If you’re only a little bit right with your crisis predictions, the risk reward ratio is massively in your favor. If you’re wrong, the consequences appear to be slow losses that lose a couple of percentage points per quarter. If you’re feeling edgy, I think it’s a great strategy to run in the background to calm your mind.

Filed Under: Trading strategy ideas Tagged With: contrarian, dot com bubble, ES, etf, financial crisis, forex, futures, margin debt, moving average, Put call ratio, risk reward ratio, S&P 500, SPY, stocks, VIX, volatility

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