Risk Latte - Why Hong Kong Stocks should Fall? – Indications from the Volatility Index

Why Hong Kong Stocks should Fall? – Indications from the Volatility Index

Team Latte
Feb 14, 2005

As measured by Risk Latte’s proprietary volatility index, HIXX™ and the Hurst coefficient of the HIXX™ all indications are that the Hang Seng Index is going to fall in the next three to six months.

Fall to what level? Will it be a correction or a trend reversal?

Well, we believe that it will be a trend reversal and the Hang Seng can fall to as low as 11,000 or even 10,500 within a span of around 200 days beginning anytime within the next 3 to 6 months.

How can we be sure? What is our analysis and what kind of a model are we using?

We draw our conclusions from two very powerful models, one mathematical and the other one a bit more empirical.

Volatility model is fast gaining currency and it is the biggest empirical find of the last decade. This model connects the implied volatility to the underlying asset. Volatility, or more accurately implied volatility, which is very difficult to model mathematically or cast inside a deterministic input-output equation can be used to create a volatility index which over a reasonably long period of time varies inversely with the underlying equity index (or the stock) from which the implied volatility(ies) is derived. The best example of this is the VIX – the volatility index on S&P 500 index and the underlying S&P500 index itself.

In fact, it is now an accepted fact that, empirically speaking, as the implied volatility of an asset increases the underlying asset decreases and vice versa. The best way to understand is this to consider the fact that every time a certain market falls the traders try to mark up the volatility in anticipation of more selling pressure. This gets manifested in higher option prices, especially put option prices.

In the same way, and much more simplistically, if the volatility index – which is calculated from many different implied volatilities of the options on the underlying index (asset) – increases then the underlying equity index decreases and vice versa. Volatility index is a fear and sentiment gauge and measures investor paranoia as displayed in the prices of equity options on the index.

A volatility index is the best and the most accurate way to capture the implied volatility of a certain index (or an asset).

HIXX™ is Risk Latte’s proprietary volatility index on the Hang Seng index and for a period of March 4, 2004 to Feb 3, 2005 (nearly a year) it has a correlation of -0.71328 (minus 0.71328). This matches very well with what is observed with the VIX and the S&P500 for the same period (a correlation of -0.7517) and demonstrates what we have said earlier, i.e. HIXX™, the volatility index and the Hang Seng Index are inversely correlated.

Hurst coefficient is the output of another mathematical model, namely Rescaled Range Analysis which measures the trends in non-linear time series. The daily values of HIXX™ values is a non-linear time series and for the same period – March 4, 2004 to Feb 3, 2005 – we calculated the Hurst coefficient and it turns out to be 0.385.

A Hurst coefficient of less than 0.5 means anti-persistence or signals a trend reversal whereas a Hurst coefficient of greater than 0.5 means persistence, or continuation of the current trend. A Hurst coefficient of 0.5 means a perfect random walk. Any value greater or less than 0.5 implies that markets follow a random walk with a memory.

The current value of the Hurst coefficient of 0.385 for the HIXX™ signals that the HIXX™ can soon reverse the current trend and move in the opposite way. The current trend of HIXX™ has been downward for the last one year. The implied volatilities have been falling all across for a long time now and our volatility index hit an all time low of 13.87 on Monday, February 7, 2005 . Putting this in perspective, the historical volatility – as opposed to implied volatility – of Hang Seng index has always had a bottom at around 20% over a 15 year period.

We believe that the HIXX™ will soon hit a bottom and even if it flattens out a bit during this bottom in 3 to 6 months time the trend will be reversed and the HIXX™ will start to go up. A rising HIXX™ will mean a falling Hang Seng index.

(These notes, articles and reports ("the Content") are prepared by the staff of Risk Latte Company Limited, Hong Kong ("the Company") using various sources, such as books, articles, research papers, websites and conversation with experts; the Content is strictly not for sale or re-distribution. In all cases the Company either seeks explicit written and/or verbal permission from the source (third party) to disclose certain facts in the Content on an "as is" basis and/or make minor or substantial modifications to the facts or to clearly delineate the source of the facts so disclosed in the Content as well as all intellectual property associated with it. The Company does not own the intellectual property of any of the products, processes and/or ideas mentioned in the Content, unless stated explicitly, and the Content is strictly for educational purposes. The Company cannot and does not guarantee the authenticity and/or the veracity of the facts, figures and events mentioned in the Content and does not accept any responsibility for any facts, figurers and events mentioned in the Content.

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