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Minyan Mailbag: Measuring Index Volatity


Think of volatility as the price of liquidity.


Prof Succo,

This morning the HGX (Philly Housing Index) opened -24 points or -4.5% after Toll Brothers (TOL) reduced guidance. The daily range on the index is 3 points or less than one percent.

It seems odd to me that 10's of millions of shares in the companies that make up the index would all trade in such a narrow range.

Would you agree? Is there a structural reason, such as next week's expiration?

Minyan L


Most broader based indexes like the SP500 trade at lower volatilities than narrow indexes or stocks because of correlation: a broader based index will have some stocks up and some down on any given day thus mitigating the volatity of the entire index. That happens less for narrower indexes (because there are less stocks and those stocks tend to have an underlying correlation factor like being in the same industry).

When index volatility picks up it is because correlation between the underlying stocks pick up.

The reason the HGX index volatility has been low is that the volatility of the stocks has been low, not because correlation is low. The charts of the volatilities of the stocks are very similar to the volatility of the index.

Think of volatility as the price of liquidity: since these stocks have been liquid in a range, their volatility tends to be low. As they break out of a range and become less liquid, their volatiity picks up.

The actual volatility of the index has picked up recently from around 20% (implying a 1.2% daily move) to 35% (implying a 2.2% daily move).

I agree that it has been low and is now probably more at fair value.


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