Rule Based Investing

Book by Chiente Hsu

Review and Article by GlobalMacroForex

Chiente Hsu makes the case for rule based investing which is an objective set of criteria to allocate assets and manage risk.  These rules are clearly and convincingly laid out using the following techniques:


-Implied Volatility of options curves


-Swap rate volatility

-Bid/Ask spreads

-TED Spread

-Credit Default Spread Curve

-Investing in EM currencies over EM stock market ETFs

Let’s dive right in and cover each of these…


Chiente Hsu discusses how market volatilities are not evenly distributed but tend to come in clusters.  Low volatilities make it more likely that the next day’s data will be a low volatility and the same pattern is seen with high volatilities.  Market crashes, war, and extreme natural disasters tend to produce high volatilities in waves.  Mathematically this is described as heteroscedasticity, or unevenly distributed numbers.  (The opposite of which is homoscedasticity).

In a normal moving average, the most recent data is averaged to judge movements in comparison with a flat average.  In an exponentially weighted moving average, weights are assigned to most recent data with the weights being less and less as time goes further back.  The GARCH is a statistical tool that takes the exponentially weighted moving average of volatility and combines it with a weight for the long-term volatility. 

In other words, it’s the most recent volatility data weighted by how recent it is, PLUS some weight for the long-term volatility.  This seeks to capture the immediate changes in the data as well as the long-term trend. This video from Bionic Turtle does a great job at showing you the formula for how to apply GARCH in excel.  The author Chiente Hsu suggests you use the GARCH to signal when to invest in short volatility of the USD/JPY or S&P500.

Keep in mind that the GARCH is regressive, meaning it’s using PAST data and applying it to the future.  It’s taking the immediate information and combining it with the long term.  However, how much it assigns to each is up to you to decide the weights.  It stands for Generalized AutoRegressive Conditional Heteroskedasticity (GARCH).

Implied volatility of options curves

Options following the Black-Scholes formula have an implied volatility in the price, in other words, given the price of the option it assumes a certain amount of unpredictability or variation in future prices.  This is said to form a “volatility smile”.  The nickname comes because the cost of the volatility increases as it moves further away from the option’s strike price.

When these implied volatilities reverse and the volatility smile turns to a “frown”, it means market participants are more unsure of the immediate term than the far away future.  This is a huge bear/negative for shorting volatility.

When the implied volatility of options curve is inverted (frown, or any other shape), just like the inversion of the government bond yield curve, it is a predictor of bad times ahead.  The following is a drawing I made to show the similarities with the government bond yield curve.  The volatility curve may not take this shape, it’s for illustrative purposes only.

According to Investopedia,

“The volatility smile was first seen after the 1987 stock market crash, and it was not present before. This may be the result of changes in investor behavior, such as a fear of another crash or black swan, as well as structural issues that go against Black-Scholes option pricing assumptions.”


The S&P500 options traded on the Chicago Board Options Exchange (CBOE) also have an implied volatility to them, meaning an expectation of the future price movement in a given time frame.  The VIX is an index compiled by the CBOE taking into account 30 different S&P500 options to gauge the “fear” or implied volatility of the market.

Chiente Hsu recommends using upwards movements of the VIX as a negative indicator of a good time to short volatility since the VIX usually proceeds volatile periods.

Swap rate volatility

Swaps are over the counter contracts where one party trades a fixed rate of return for an unknown floating rate such as LIBOR or US government bonds.  The purpose of a swap might be for one party to hedge an unknown risk with a fixed payment, for example, a bank could offset a variable liability with a fixed income asset. 

When measuring an extreme increase in the volatility of the swap rates, this tends to be associated with a period of risk aversion and is again a bad time to short volatility.  From the CBOE, You can find the Swap rate volatility here.   The CBOE index functions similar to the VIX but it’s for over-the-counter swaps.

If you want some raw numbers, you can find the US Treasury swap rates here.  But keep in mind that this is an over-the-counter market, so that website’s numbers may not be accurate.

Bid-Ask Spreads

Market makers buy and sell assets to create the market.  In doing so they take on some risk which they have to hedge with an offsetting position.  The premium they take for this the “spread” or the difference between the bid (sell) and ask (buy). In times of uncertainty, the bid-ask spread widens as dealers require a larger premium to match these offsetting positions and typically there is less liquidity in extreme volatility as one side overwhelms the other.  As this chart from the Reserve Bank of Australia demonstrates, the spreads can vary wildly and spike in times of uncertainty.

Chiente Hsu says investors should track and monitor the bid-ask spread of forex pairs such as USD/JPY and when the spread increases to not short volatility.  You can find the forex bid-ask spreads here.

TED Spread

For more information on interbank lending, see my article on how the interbank clearing system works.

Banks lend to each other on the interbank market, if it’s through the Federal Reserve for overnight lending, this is the Fed Funds rate.  If it’s through a private broker, then it’s a privately negotiated rate.  These private brokers match buyers and sellers of money for various maturity lengths.

Despite the fact that the interbank market relies on privately negotiated rates, many people watch LIBOR.  LIBOR (which stands for London Interbank Offer Rate) is an index compiled by ICE.  ICE took over from the British Bankers Association after they were found to have committed rampant fraud.  Now people consider this ICE LIBOR number to be more reliable than BBA LIBOR, however, they both are still the banks’ opinion of what the interbank rate is since it’s not based on actual lending.  The number is compiled by asking banks how much they would charge to lend at different time lengths.  Then the highest and lowest numbers are chopped out and the rest averaged.

People watch LIBOR even though the actual lending is done through private brokers at different agreed on prices.  The US government agreed in 2017 to phase out LIBOR because it is so corrupt.  In the meantime, the 3-month LIBOR is the most watched number in the market because the 3-month Eurodollar rate is the most liquid contract trading LIBOR rates and it’s generally consistent with a bank’s hedging needs.  When the 3-month LIBOR is subtracted from the 3-month T-bill, this is the TED Spread.  In other words, how much extra premium the market asking to lend to a risky bank vs the “trustworthy” US government.

TED Spread: 3-month LIBOR minus 3-month US Treasury Rate

Chiente Hsu recommends watching the TED Spread as a negative indicator of volatility shorting, and to use it as a screening factor in overall investing.

Credit Default Swap Curve

A credit default swap (CDS) is insurance against bond default.  One party underwrites it by agreeing to pay when the borrower defaults.

In the above picture, when the borrower defaults, the insurance company pays the lender (buyer of the CDS).  However, the buyer of the CDS doesn’t have to even be the lender!  It could be a third party speculator.

Because CDS are readily available to anyone with enough money to buy it (only large institutional investors can actually afford them) then the rates are publicly available (for example on Bloomberg) for trade.

Similar to a yield curve inversion, when the CDS rates for the immediate future are higher than CDS rates for farther away for a given government’s bonds, this is a bear move for buying bonds in that country.  It’s also a bad time to get that country’s currency or short volatility.  This is because the market is implying that the immediate future is more unstable/unknowable than far away.

Emerging Market Carry Trade

Chiente Hsu tells us that emerging market stock markets don’t move with economic growth the same way that developed markets do.  She recommends instead we invest in the currency to benefit the most from that growth.  Hsu points us to an article from Jay Ritter in the Journal of Applied Corporate Finance entitled “Is Economic Growth Good for Investors?” which questions if macroeconomic growth is actually beneficially to equity prices.  Mr. Ritter’s study which studied 19 countries found between 1900 and 2011, between GDP and equity prices, the correlation is -.39.  Hsu writes this may be due to the stock returns being based on individual “corporate earning growth per share, not economy-wide corporate earnings”.

Chiente Hsu points out that the correlation between emerging market GDP growth and currency appreciation is 21%, whereas the correlation with EM equities indices is -6%.    While many investors would shun EM currencies due to the lack of liquidity, Hsu points out how in recent years that has significantly improved with a 210% increase in daily volume turnover from 2001 to 2010 according to the Bank for International Settlements.  In addition, while Hsu does admit EM currencies are much more volatile than G10, ultimately based on their Sharpe ratio, the risk is worth the reward.

The Sharpe ratio is the return minus the risk-free rate, divided by the standard deviation.


Chiente Hsu makes the case for shorting volatility through rule-based investing, using techniques such as the direct sale of options, derivatives that trade the VIX, as well as going long things such as USD/JPY, emerging market currencies, or EM government bonds.  The strategies are divided into carry, short volatility, and value.  Hsu recommends picking allocation among these based on the characteristics mentioned in this article, including but limited to: GARCH, implied volatility of options curves, VIX, Swap rate volatility, Bid/Ask spreads, the TED Spread, and an inversion of the Credit Default Swap Curve.