Investing Caffeine

Ray Allen, the VIX, and the Rule of 16

June 13, 2010 at 10:50 pm 2 comments

Photo Source: Babble.com

Ray Allen gets paid a lot of money for running into people and bouncing an orange ball around a wooden floor, but even his game can appreciate the importance volatility can play in a high stakes game. First, Allen set an NBA Final’s basketball record of eight three-pointers made (including seven in a row) in Game 2, and then followed up in the next game with an astonishingly dismal “O” for thirteen performance – the second worst shooting performance during a Final’s game in 32 years. The emotional rollercoaster ride for the Celtics fans resembles a volatility chart of the VIX (Volatility Index) in recent weeks.

Chart Source: Yahoo! Finance

In the last 40 trading days the VIX has moved more than +/- 5% on 30 different trading sessions (75% of the time), including seventeen +/- 10% trading days. The +32% spike in the VIX on the day of the “Flash Crash” (May 6, 2010) would have even generated a smirk on the face of Ray Allen, not to mention the face changing impact of the other three +/- 30% move days that occurred within a month of the Flash Crash trading debacle. Even though the VIX has settled down from a short-term peak last month (48.20 on May 21^st) to a lower level (28.79), the fear gauge still stands at almost double the rate of the multi-year low just a few months ago (15.23 on April 12^th).

The VIX and the Rule of 16

No, this VIX is not the same as the Vicks vapor rub medication placed on your chest to relieve cough symptoms, rather this VIX indicator calculates inputs from various call and put options to create an approximation of the S&P 500 index implied volatility for the next 30 days. Put simply, when fear is high, the price of insurance catapults upwards as measured by the VIX – just like we saw when the VIX spiked above 80 during the 2008 financial crisis and above 40 during the more fresh Greek debt disaster. I’m not in the position to bust out some differential calculus to explain the nuances of a complex VIX formula, but what I can do is regurgitate a helpful formula relating to the VIX, called the Rule of 16. What the Rule of 16 allows laymans to do is understand the relationship between the VIX and daily volatility.

This is how Jeff Luby of Green Faucet describes the Rule of 16:

• VIX of 16 – 1/3 of the time the SPX will have a daily change of at least 1%

• VIX of 32 – 1/3 of the time the SPX will have a daily change of at least 2%

• VIX of 48 – 1/3 of the time the SPX will have a daily change of at least 3%

To put these VIX numbers in perspective, industry citations put the long-term VIX average around a level of 20. With a VIX hovering around 30 now, we are approaching the 2^nd bucket of expectations (2%+ moves in the market 1/3 of the time). The price moves don’t correlate directly with the Dow Jones Industrial Average index, but I think about the current VIX levels equating to about a +/- 200 point move in the Dow one or two times per week…uggh.

Generally, I would prefer lower volatility, but I continually remind myself volatility is not necessarily a bad thing – volatility creates opportunities. I’m not sure if I can apply the Rule of 16 to Ray Allen’s scoring output, however based on last night’s 5-10 shooting performance, perhaps volatility in the market and Ray Allen’s shooting game will begin to normalize toward historical ranges.

Wade W. Slome, CFA, CFP®  

Plan. Invest. Prosper.  

www.Sidoxia.com 

*DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds (including S&P 500-like positions), but at the time of publishing SCM had no direct positions in SPX, VIX-related securities, or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

Entry filed under: Education, Trading. Tags: Boston Celtics, Ray Allen, Rule of 16, VIX, volatility, VXX.