This August, individual investors have been grossly underestimating the amount of volatility that still remains in stocks. Today, I want to introduce you to a much better tool to gauge market volatility…

Normally, in trending markets, volatility is a good thing for traders. It means that the market’s making bigger moves, and our average gains increase as a result. In ranging markets, like the one we’re in now, volatility is significantly less appealing — it means that risk is being applied much more haphazardly.

It pays to understand what the market’s volatility levels look like before you take any trade…

Not surprisingly, plenty of people have been trying to predict when the volatility will decrease to more normal levels. Usually, people refer to the VIX volatility index when they’re trying to measure the level of volatility in the market. But that’s a big mistake…

The VIX measures the implied volatility of the S&P 500 — in other words, it measures how much risk people are pricing into “the market” as a whole, not how much risk there really is. It became popular during the crash of 2008, when stocks were in free fall, and volatility was soaring.

But the VIX isn’t a very good volatility indicator at all. When traders aren’t pricing in adequate risk, the VIX doesn’t tell us the true amount of volatility in the market.

And that’s not all…

The VIX is, seriously, negatively correlated with the S&P 500. As a result, it increases primarily when stocks are quickly moving lower. If stocks are moving higher just as quickly, it doesn’t register. That’s a crucial shortcoming to keep in mind when gauging volatility in this market. The VIX is a great way to measure “fear” in the market, but it’s a pretty poor way to measure how volatile things are right now.

Instead of the VIX, I’ve got a better volatility indicator to show you. It’s called a Bollinger Band.

Developed by analyst and money manager John Bollinger in the early 1980s, Bollinger Bands measure a stock’s volatility by charting a band that’s a specific standard deviation away from its moving average. As a result, Bollinger Bands are adaptive to the market, and they’re based on what’s actually going on in the market — instead of relying on how investors are pricing risk.

The space in between the two bands is known as the bandwidth; it’s an excellent measure of volatility in the market. The wider those bands get, the more volatile a stock is.

The chart below of the S&P 500 shows just how volatile stocks still remain right now:

Above: Bollinger Bands set around the S&P 500 index. Subchart shows bandwidth.

As you can see, the market’s bandwidth is currently 25.1 — from a daily time frame, that’s the highest we’ve seen volatility since back in March 2009, when the market set its secular bottom. For comparison, the VIX didn’t even set as much as a new quarterly high in August.

There’s a considerable amount of hidden volatility in the market right now.

The key to wrangling this market is going to be harnessing that volatility when it becomes directional — and sitting aside while haphazard trading continues. Don’t underestimate the risk in stocks this month…

Cheers,

Jonas Elmerraji
Penny Sleuth

A Better Way to Gauge Market Volatility was originally featured in the Penny Sleuth.

Don’t think that anyone – present company included – is immune from the frustrations of seeing portfolio positions dip or watching as the S&P 500 sells off for yet another consecutive day. But stock market frustration only becomes a real problem when it starts to interfere with your decision-making process. Now more than ever, it’s crucial to follow your preset trading rules, and stick to the system.

Whenever you enter a trade, you should go in thinking about your exit plan from the start, whether the stock performs as expected or it doesn’t. Those two price levels need to be dictated by predetermined analysis, not by how we feel about the market; when used to guide your trading, they can spare you from premature selling.

It’s all about having perspective. With the right context for a stock’s move, suddenly sell-offs aren’t panic inducing. Today, I want to share some of the market context that my Penny Momentum Trader readers have been benefiting from:

I’ve been putting a lot of emphasis on the technical significance of the 1,300 level in the S&P 500 since late 2010. So, can you guess where last week’s sell-off stopped?

That’s right. Despite some flirtations in the mid-1,290s for around 20 minutes on Thursday, the S&P held up above our technical support level nearly perfectly. Remember, it’s important that the market is following our technical cues – it means that last week’s price action is probably just a healthy correction, and that our cautiously bullish outlook for the near-term continues to hold. Even though we were able to pin the market’s “floor” within a few points, I want to stress for newer members that we’re not in the business of making predictions here. As technical traders, we’re focused on contingent expectations – a framework for trading that’s based on if/then rules.

If the market stays above 1,300, we’ll continue to be cautiously bullish…

So that said, what would we like to see as we enter the first week of March? Ideally, we’ll get a bit of sideways consolidation in the S&P 500 this week as the market cools off from the rollercoaster ride we’ve just endured.

Cheers,
Jonas Elmerraji
Managing Editor, Penny Sleuth

March 1, 2011

Avoid Serious Losses By Following the Rules was originally featured in the Penny Sleuth.

Before 2008, the VIX wasn’t a household name for most retail investors. But as the index, which measures the implied volatility of the S&P 500 index, rose to new highs amid the crumbling stock market, this unique index got more than its fair share of attention. That said, ask even the most fervent market observers what the VIX really is, and you can expect answers to diverge a bit…

So, what exactly is the VIX?

The VIX’s full name is the CBOE Volatility Index. Essentially, this measure of volatility was created in 1993 for the Chicago Board Options Exchange (CBOE) by then Duke University Professor Robert Whaley to represent the market’s expectation of market volatility for the next 30 days.

Simply put, the VIX is a good indicator of just how much investors can expect prices in stocks to swing. A higher number means bigger moves (both up and down), whereas a smaller number indicates smoother sailing ahead…

But the VIX is actually designed to tell us much more than that – the value of the VIX is actually significant too. It tells us the expected movement of the S&P on a percentage-point basis.

Let me explain…

As I write this, the VIX sits at 19.46. That number is the expected annualized price movement of the S&P 500 in the next 30-days. By digging up a bit of finance class math, that tells us that right now investors are expecting the S&P to move 5.48% (either up or down) in the next 30-days. Although that’s a potentially large percentage move, it’s still far from game changing volatility.

That said, there’s another element of the VIX to look at – where it’s headed:

Taking a look at the chart above, a few things are clear about the VIX’s price action. For starters, the index has been trading in a downtrending channel. And for another thing, it looks like the VIX is finally finding support near its 52-week low of 15.23. With Friday’s test of channel resistance, a change of trend could be underway for the VIX.

For traders, that could be a very big deal – especially if volatility moves back toward previous highs:

• In May, the VIX hit a near-term high of 48.2, which suggests expected single-month moves of 13.9% in the S&P 500… That’s major volatility.

• In October 2008, the VIX hit a blistering all-time high of 96.4. That means that the markets were pricing in monthly expected volatility of 27.8%!

From a technical perspective, every time the VIX has tested support in the low 15 range (weekly), the index has bounced back significantly higher. Since the last few weeks have been another retest of 15 (see the chart above), that’s indicative that higher volatility may come back into play.

If that’s the case, it’s going to be crucial to wait for a broad trend in the S&P 500 and Dow before jumping into stocks. Remember, the VIX indicates movement in either direction, so unless an uptrend is defined, stocks can just as easily move lower.

Obviously, this is a theme we’ll be keeping a close eye on in 2011…

Cheers,
Jonas Elmerraji
Penny Sleuth

February 1, 2011

Don’t Be Afraid of the “Fear Index” was originally featured in the Penny Sleuth.

Keep this volatility tip in mind and you’ll be well on your way to profiting from the price swings…

It can be nerve-racking to watch a stock pinball. And if you own shares of any penny stock, you have to be able to spot whether or not the stock is taking a turn for the worse. But wild price swings don’t always mean that there’s cause for concern in your small-cap portfolio.

OTC Is Inherently Volatile

Volatility is inherent in any small-cap stock, but that’s especially true of stocks that trade over-the-counter, or OTC.

And now, with volatility higher than ever on the big boards – like the NYSE and the NASDAQ – as well, the volatility we’re seeing in the penny stock arena is unprecedented. That’s why we need to consider the cause of the volatility, because the reason for a price swing can often tell us quite a bit about where prices are headed next.

First, you need to look at the bid and ask.

The bid – the price that investors are willing to pay for shares – and the ask – the price shareholders are willing to sell shares for – are key parts of how shares of a stock are priced. With blue chips, the difference between the bid and ask price (known as the spread) is tiny, but for penny stocks spreads can be enormous.

Just look at WordGate Communications (OTC: WGAT), which has a 4 cent spread as of Friday morning. With WGAT currently trading at $1.04 per share, that spread represents almost a 4% of the company’s share price – and many OTC stocks have much higher spreads.

That’s largely a product of volume, which is the number of shares that trade hands during trading. Because investors set the market prices of stocks by their buying and selling activity, all any stock needs to make a serious move (up or down) is trading volume. That’s why it’s exciting to find a stock that can make a big move without a lot of extra buying power behind it.

You may have heard a broker or trader talk about a stock that “moves on air.” Simply put, it doesn’t take a lot of extra buying to get shares to blast off. That’s why traders are always looking for “low floaters.” These are the stocks that don’t have a lot of shares that are unrestricted and available for trading on any given day. That’s often true of penny stocks – with relatively low trading volume on any given day, small share transactions can be a major component of share price.

That’s why OTC stocks are so powerful. Little bumps in volume can translate into huge moves in the share price. That was certainly the case with WGAT – shares have rallied 134% in the last month alone thanks to a volume-induced push. And other OTC plays, like IMAGING3 Inc. (OTC: IMGG) have fared even better, pushing 1,580% in the last thirty days.

That’s performance that you’ll only find with bulletin board stocks…

When investor interest returns and volume picks up — thanks to positive news, earnings or guidance — the spread should shrink and the stock should move up nicely.

Just look at the real-time streaming quote generator on your online brokerage site. Type in your favorite blue chip and you’ll see a flurry of activity. Thousands upon thousands of shares will trade in a matter of seconds right before your eyes.

Now type in WGAT or IMGG – two OTC stocks that we’ve been getting quite a bit of reader mail about recently. If it’s a busy day, you could see the bid or ask tick up and down a bit, with a few thousand shares exchanging hands over the course of the morning. But then there are the slow days, when the stock barely moves at all…with a painfully large spread.

That’s nothing to worry about. Just remember this: If there’s no unusual volume backing up a drop, chances are the move won’t hold. Sometimes you’ll see a “shake” — the stock price taking a dive on the sale of just a few hundred shares. Don’t fall into this trap and sell…prices will more than likely return to previous levels sooner, rather than later.

Cheers,
Jonas Elmerraji

September 25, 2009

Why Volatility Equals Profits for Small-Cap Stocks was originally featured in the Penny Sleuth.

*** Hopefully, by now, you have received your invitation to join Carl Waynberg and his GRIP system — on what promises to be an exciting small-cap journey through the OTCBB and Pink Sheets markets.

If you’ve ever wanted to dabble in true penny stocks — this is your chance.

We’re only letting 3,000 people join. So if you haven’t signed up yet, please do so quickly. You have until Jan. 1 to sign up and receive your 80% discount. But once the new year rolls around, the entry price will more than double! So please take advantage of this limited time offer.

*** “James, have you looked at shares of VSL in a while?” asked Penny Stock Fortunes editor Angela Roberts over instant messenger yesterday afternoon.
“They’re up over 30% since you got in!”

Of course, I had been watching. And the rise really didn’t surprise me — although it was welcomed. You see…

VSL is the ticker symbol for Indian telecom giant Videsh Sanchar Nigam Ltd. Its headquarters are just outside of Mumbai, India (also known as Bombay here in the West). And it is widely considered the AT&T of India — connecting India with 237 international destinations around the world.

I recommended shares of VSL last winter — when they were going for $7.95 a share. At the time, that was dirt cheap. You see, the company was trading for seven times earnings and less than book value. Plus…

India was adding 2 million phones a month, and GDP was predicted to keep growing right around 8% a year. Recommending VSL seemed a no-brainer. And today, less than one year later, shares of VSL are trading for $10.39. We’re up 30% in 10 months. Not a bad return on your investment.

So why the huge rise?

One could argue fundamentals. The stock was inherently undervalued at the time. But in this case, I think it’s something more than simple stock fundamentals.

I recommended shares of VSL because it was an Indian stock. I knew India had a serious chance to become the “Next Asian Superpower.” It had the people power. It had the technological know-how. (Bangalore, located in southern India, is widely regarded as the Silicon Valley of Asia. In fact, more IT directors work there than in Silicon Valley!) And if India emerged like China did, companies like VSL and Mahanagar Telephone Nigam Ltd. (MTE) — the other Indian telecom company I recommended — would rise.

Well, that’s happening. India is growing. Its stock market is up 14% in the last year. And liquidity is improving each month — especially the market for small-cap stocks (which is where the HUGE gains are being made).

Nikhil Lohade, writing for India’s Business Standard reported that…

“The current market rally (in India) has seen steep gains in heavyweights, but the true sizzlers have been the penny counters, according to retail brokers.

Data show that small-value scripts have far outshone their more recognized peers in terms of meteoric gains in their prices.”

Lohade goes on to quote Rajesh Kamdar, an Indian dealer at KG Vora Securities…

“The current rally has been driven by liquidity, mostly foreign, in front-line stocks. But retail participation has been huge in smaller stocks.”

Translation…

Indian small-cap stocks are rising because a lot of foreign money managers are dumping cash into the market now. They are seeing the opportunity that exists in India (especially with the smaller companies on the major Indian exchanges). And they are buying, buying, buying.

That’s exactly why shares of Indian stocks like Capman Financials, SGN Telecoms, Howard Hotels, Yashraj Containeurs and Polymechplast Machines are up anywhere between 347-1,405% a pop. And it’s exactly why shares of VSL are up over 30%.

As a small-cap investor, it’s important to recognize opportunities all over the world. And as we move into a new year, there will be hundreds of chances for you to make money. Not all of them will be in U.S. stocks. In fact, the best opportunities to really multiply your money are ALWAYS in an emerging market — like India or China.

In fact…

*** Dan Denning, editor of Strategic Investment, just send me the latest ETF inflows report. It shows where the “smart money” is flowing. For the week ending Dec. 24, $1.2 billion was dumped into ETF funds. And the two standout winners were foreign funds and small-cap funds. Check it out…

Foreign and global funds received $304 million, while $423 million poured into the Russell 2000 small-cap fund — IWM. Collectively, 60% of the total equity inflow went to buy small caps and foreign stocks…and a pretty bullish sign for the argument I am trying to make.

As you think about your own investment strategy for 2005, you would do well to
consider small-cap stocks and emerging markets. So…

Who knows what the next emerging market will be?

I expect India to be a force for the next decade — which is why we are still holding onto shares of VSL. But I also expect countries like Mexico, Nicaragua, Argentina and other Latin American countries to emerge.

Look for more on emerging markets here in Sleuth. I have a feeling we’ll find more than one opportunity to help you profit in 2005. But for now…

Irwin is going to take you on a retrospective look back at the U.S. small-cap market of 2004. It was quite a bumpy ride — that’s for sure. But those who stuck with us…well…they made some nice money.

Irwin, what the heck happened this year?

Gunning for Profits in 2004

What’s the single most important lesson we small-cap enthusiasts learned in 2004? My friends, it’s this: Stick to your guns.

Congratulations to those of you who held fast during the razor-thin election polls, earth-shattering crude prices and Greenspan’s serial interest rate hikes. Because the Russell 2000 small-cap index rewarded us yesterday with an all-time high of 651.72. Incredible!

The Russell 2000 fought hard for each and every winning point — reminding me of boxing legend Muhammad Ali. The Russell 2000 danced on its toes in the early quarter, and then sustained body blows in the middle quarters, only to finish with a dazzling victory. And here in Baltimore, your devoted Penny Sleuth team was ringside throughout.

We went into the year fully aware that small-cap cycles typically last 5-7 years. Since our current cycle started in 1998, we knew that things could turn on a dime. Remember: Small-cap stocks are the first to react to market changes — either up or down. Yes, your Penny Sleuth team was enjoying the ride, but frankly, some folks here were starting to pensively nibble their lower lip.

We spent many late nights during 2004 holed up in the office analyzing the charts, graphs and newswires until our eyes were bloodshot. I’ll admit that, like yourself, we were tempted to cut expectations, flip-flop investment strategies or sell off everything as we prayed for saner times. But we didn’t. And I’ll tell you why…

Here at Penny Sleuth headquarters, we have volumes and volumes of data at our disposal. We constantly study what happened in previous bull markets. And we had a strong hunch that this bull run would continue all throughout 2004. After all…

From 1926-1996, small-cap stocks consistently outperformed large-cap stocks. After 10 years, small caps beat large caps 67.7% of the time, that number growing incrementally over longer periods to a full 100% after 25 years. That’s a scientific fact. And the major reasons for it are innovation, undervaluation and volatility.

Taking those three criteria into consideration, our bull market outlook had a slight permutation to it. While the first quarter was characterized by high-risk speculation, we expected that to change into a longer-term, more conservative holding pattern as the election approached. Regardless, whether it was raw profit-taking or long-term investing, we had no reason to believe that small caps would disappoint.

In part, that’s because we knew that when it comes to innovation, small-cap
entrepreneurs are a driving creative force behind the kinds of inventions that large-cap companies ignore…opening the door for a windfall. Look no further than Cyberonics, Inc., Acacia Research Corp. and SiRF Technology Holdings, Inc.

Cyberonics is a maker of implantable medical devices that treat neurological disorders. When it announced FDA approval of its patented epilepsy treatment, on June 16, the stock shot up the next day by $15.23, or a whopping 78%. Imagine that a 78% gain in 24 hours. That’s the kind if innovation that you find with small-cap companies. And a 78% gain is the kind of a return you can get if you stay committed to your investment strategy.

On March 15, Acacia announced a deal with Playboy for its state-of-the-art patented streaming media system — sending Acacia’s stock up 14.5% over the next four days, from $6.13 to $7.02.

And Aug. 31 saw an announcement from SiRF that Microsoft was adopting its global positioning system for a travel and mapping application. Bear in mind that SiRF has 71 U.S. patents and 96 U.S. patents pending. That innovation coupled with Microsoft’s market clout catapulted SiRF’s stock into the stratosphere for the entire month of September, going from $9.98 on August 31 to $14.04 on Sept. 28 — a breathtaking climb of 40.7%.

One more important point about small-cap profitability before we continue.

Since the stocks are generally undervalued, they have a much greater capacity for rapid growth (and decline) than the more mature and stodgy large-cap stocks. After all, when was the last time you saw IBM, Procter & Gamble or General Motors shoot up 78% overnight? It’s nearly impossible.

And that kind of small-cap growth occurs year in and year out.

In 2003, the Russell 2000 gained a record 47.3% — crushing the large-cap
Russell 1000, which itself posted an impressive annual rise of 29.9%. That 17.4% gap marked the fifth straight year that the Russell small-cap index left its bigger brethren in the dust. Racing across the finish line of 2003, we entered 2004 with the pedal to the metal.

Strapped in for a great ride, the first three months of 2004 were amazing. The Russell 2000 surged ahead 73% over Q1 2003. Small-cap adrenaline junkies ignored the grim reports of unemployment, Mid-East insurgents and Haliburton. Euphoric on the fumes of 2003, they extracted heady profits from the small-cap boom.

For example…

If you owned stock in biotech star Incyte Corp., your Q1 price increase rose 21.9%, from $6.82 to $8.31. Tech company Input/Output, Inc. also made small-cap investors big money in the first quarter by jumping from $4.65 to $7.75 — an increase of 66.7%. And Whiting Petroleum Corp. scored a 25.2% gain as it went from $18.84 to $23.59 for the quarter.

You could just hear Prince singing, “I’m gonna party like it’s 1999.” But in retrospect, that was the anthem for the tech bubble burst of 2000. So we should have known that the encore would be a cry of panic.

Going into Q2, sharp job gains and other positive indicators set off chatter about short-term interest rate hikes. For us, that was bad news. Even thriving small companies often need cash to stay competitive. They spend the money on important programs such as R&D, marketing and channel development. But any company with a market cap of $1 billion or less is considered high risk by steely bank officers. That translates into higher interest rates, which come straight off the bottom line.

Toward the end of Q2, gargantuan monsters that went by the names of Ivan, Jeanne and Frances messed up oil producers in the Gulf of Mexico. In conjunction with other oil industry worries, the worst hurricane season in 40 years triggered wild speculation in oil prices — with the logical effect of weakening stocks. Naturally, investors ducked for cover. Dumping their riskier small-cap holdings, they made a bee dive for large caps.

By the way, there was one more hurricane — of the financial variety — that went by the name of Alan. In June, when meteorologists started predicting a nasty hurricane season, Chairman Greenspan bumped up short-term interest rates for the first time in four years, by a quarter point.

So for the second quarter, the large-cap Russell 1000 surpassed the Russell 2000 — for the first time in five quarters. The Russell 2000 returned a paltry 0.47%, compared to the Russell 1000′s yield of 1.40%. Although the spread was 197.9% in favor of the large caps, neither of the indexes set off fireworks. But the reversal would start a downward small-cap trend.

We began to wonder…

Had the small-cap rally of 1998 finally hit a wall? Were the artificially low short-term rates merely a facade for small-cap companies with lousy fundamentals? And would fund managers completely rotate out of small caps in favor of Wal-Mart, PepsiCo and ConAgra — smashing our favorite stocks?

These questions and others plagued us here at Penny Sleuth late into the night. Crunching numbers, downing coffee and dissecting research, we couldn’t help but wonder if the sirens screaming by our office every five minutes were an alarming metaphor for the Russell 2000…and a small-cap rally reaching its theoretical limit.

As expected, large caps outperformed small caps for Q3 — although both coughed up a negative return (unexpected). The Russell 2000 lost 2.9% versus minus 1.8% for the Russell 1000. But we weren’t ready to throw in the towel yet. We knew small-cap stocks were in a massive bull run. And we were right.

Here’s a snapshot of the forces at work going into the fourth quarter…

To fight inflation, Greenspan’s interest rate hikes had reached 2%. But postelection rapture overcame the extra financial burden to small-cap entrepreneurs by sending the Russell 2000 upward from 585.44 on Nov. 3 toward what we believed at the time was an all-time high of 609.61 on Nov. 10.

But think again…

Because yesterday, the Russell 2000 became the only major stock index to eclipse its highs from the mighty bull run of 2000 by setting yet another record of 651.72.

The groundwork for this phenomenal performance was laid during the month of
November, when the Russell 2000 rose 8.8%. If you annualized that out, you’d be looking at a 70% gain for the year. Not bad. But if you annualized the Russell 2000′s performance from November, you’d be staring at gains of more than 170%.

And it got better for us small-cap fans…

During the first 11 months of 2004, the Russell 2000 was up 15%, doubling the gains of the large-cap Russell 1000, which was up only 7.5% for that period.

Here at Penny Sleuth, we were definitely sleeping easier. Still, the theoretical limit of the 1998 small-cap rally hung over us like the Sword of Damocles. Until we discovered a little-known study published by a company that sent Wall Street topsy-turvy.

Ibbotson Associates had published that shocking study that I cited earlier, which showed how small-cap stocks had beat large-cap stocks from 1926-1996. Its publication in 1999 rattled the blue bloods of Wall Street, who were born and raised to believe that large-caps ruled. Then we came across another startling piece of research from Ibbotson.

In it, they insisted that 1999 was just the beginning of a 26-year small-cap run that would once again beat the returns of the large-cap elitists. Ibbotson and company believe that through the period 1999-2025, small caps will yield a total return of 12.5%, versus 11.6% for large caps.

In the end, we were always believers. And we knew that you were too. That’s why on Oct. 12, we launched Penny Sleuth — the best guide to the small-cap universe ever to hit the Internet.

How long will the current rally last? Nobody can say for sure. But we’re sticking to our guns at least through 2025.

Happy investing,
Irwin Greenstein

December 25, 2004

P.S.
Since the past and the future are inextricably linked together, on Friday James will share his small-cap forecast for 2005.  He’s keeping it tightly under wraps until the last possible minute (even I haven’t seen it yet).  So I’m just as anxious as you are to read Friday’s Penny Sleuth.

Gunning for Profits in 2004 was originally featured in the Penny Sleuth.