At the offset one might think the statement "institutions avoid risk" is nothing earth-shattering. In fact, this statement might be considered common knowledge. What I have found, however, is that some of the best trade opportunities stem out of common knowledge fundamentals. Most analysts and traders would agree that we are in the most volatile markets seen in decades and arguably since the inception of the stock markets. Instead of running away from the rising volatility and uncertainty, the prudent trader looks for opportunity amidst the chaos.

In trading, any and every edge can make a difference. Traders are constantly searching for correlations between markets as leading indicators. Although no correlation is absolute nor remains "evergreen," I'd like to discuss one in hopes that it may help you find an "edge" in your analysis. To understand the logic behind this trend, an understanding of the VIX is needed. VIX is the ticker symbol for the Chicago Board of Options Exchange (CBOE) Volatility Index. The VIX is arguably the most popular measure of volatility. The value of the VIX is determined using the implied volatility of options on the S&P 500. As markets are harder to predict, option prices increase due to the implied volatility. Implied volatility, in most cases, is skewed to the put side; meaning puts are more expensive than calls, due to the higher implied volatility in most markets. This implies that with higher volatility, the puts are becoming more expensive at a faster rate than calls. This is also why when the VIX is rising, the stock market is expected to fall. In a roundabout way, one can look at the VIX and determine that a higher VIX reading may indicate a greater chance for a market correction and more puts being purchased. The largest purchasers of puts by far are institutions. Institutions buy puts to hedge or avoid risk. If the larger institutions are buying puts to avoid risk, they are likely avoiding risk or hedging their exposure in other ways as well.

Historically, larger institutions have consistently sold yen and bought other currencies as part of "the carry trade." The carry trade is the act of shorting, or selling a low interest rate currency and buying, or going long on a higher interest rate currency, capitalizing on the difference in yields. The yen has had the lowest interest rate over the past decade and has been the favored currency to short. Though this is a viable investing strategy with great probability, it is highly leveraged and considered higher risk by the more conservative institutional investors. In more uncertain times, institutions unwind the carry trade. In doing so, yen short positions have to be bought back, which causes the demand and price of the yen to rise as these positions are covered. This is why one can see an apparent rise in the price of yen, as there is a rise in the VIX. Though they are not directly connected, institutions hedge risk in numerous ways, causing both the VIX and the yen to rise.

Comparing the VIX with the CME Japanese Yen (continuous contract to show longer-term correlation) for the past 2 years, a correlation can be seen. In the image below, note the significant peaks and valleys of the market by the red horizontal lines. Though the magnitudes of the moves are not equal, the frequency and direction of the moves appear to adjust together. Often times, the VIX moves first. This early move provides an opportunity to be alerted to a pending yen trade in many scenarios.

Figure 1 - The VIX Compared to the Japanese Yen, Looking at Key Directional Changes.

Though more volatile in the short term, the same apparent correlation on the daily charts also occurs on the intraday day basis seen below (see Figure 2).

Figure 2 - The VIX and The Japanese Yen Intraday Comparison Chart

The strategy for trading this phenomenon is quite simple, as it can be included in a normal technical analysis routine. If using daily candles to look for investment opportunities over a period of weeks, one could wait for a significant change in direction of the VIX to either confirm a trade on the yen, or in many situations be the indicator of a potential trade. This is to say a break of resistance in the VIX, will likely see volatility rise and in turn, an opportunity to buy yen may become available. A break below support on the VIX could see decreased volatility in the markets, and a bearish sentiment for the yen would be appropriate. In one month, the VIX found a low near 20 in September and rose nearly to 80 by the end of October. This move frightened many investors in the stock markets; but taking the opportunity to buy yen in this same time period, would have generated over 1400 points on the CME Yen Future (/6JZ8) worth over $17,500.00. The E-mini Japanese Yen (/J7Z8) could have been traded as half-size to the contract and move.

As an example of an intraday set up, here is the VIX intraday forming a wedge (see Figure 3), indicating a consolidation of volatility. A break below support could see the VIX drop back to a reading of 40. A break above resistance could see volatility reach back toward previous resistance near 80. A similar consolidation is seen on the E-mini Japanese Yen (/J7Z8). If the VIX breaks to one side or the other, it is probable that the yen will mimic the move. If either of the above scenarios takes place and the future produces a similar move in price, there is potential of a substantial return in three weeks on the E-mini alone.

Figure 3- The VIX Consolidating in a Symmetrical Wedge

Figure 4- The E-mini Japanese Yen Mimicking the Symmetrical Wedge on the VIX.

Conclusion
Due to risk avoidance during volatile times, institutions will buy puts and unwind higher leveraged trades such as the "carry trade" and short yen positions. This fundamental pressure creates an apparent correlation between the VIX and the Japanese yen. The correlation has even seen the yen give early trade signals. The more conservative trade is to look for the VIX to confirm trades on the Japanese yen. The more aggressive trade being a trade on the yen, based on moves on the VIX without confirmation. For those trading CME futures, both a future and an E-mini are available for the yen. For those trading the spot Forex market, the yen is in the quote position and the above correlations will be inverted. This is to say, shorting the USD/JPY will mirror or be in the inverse of the futures.

thinkorswim, Inc. does not solicit or recommend any form of trading in the individual stocks (or their derivatives) mentioned above. Please do careful, independent research before investing any money as well as weigh the possible consequences on your particular financial situation before doing so. The risk of loss may be substantial.

Neither Investools nor its educational subsidiaries nor any of their respective officers, personnel, representatives, agents or independent contractors are, in such capacities, licensed financial advisers, registered investment advisers or registered broker-dealers. Neither Investools nor such educational subsidiaries provide investment or financial advice or make investment recommendations, nor are they in the business of transacting trades, nor do they direct client commodity accounts or give commodity trading advice tailored to any particular client's situation. Nothing contained in this communication constitutes a solicitation, recommendation, promotion, endorsement or offer by Investools, or others described above, of any particular security, transaction or investment.