A Look at Volatility
It hasn't spiked higher for a long time, but it will find a way.
Perhaps the most commonly discussed aspect of market behavior is volatility. Academic papers have been written about it, charting programs available to everyone update it in real-time, hedge funds running hundreds of millions of dollars dissect it to create their edge.
With a niche so thoroughly covered by all aspects of the investment community, there is nothing I can add that hasn't already been thought of, studied, and traded. But I have been keeping my eye on an analog that is enticing, and because of that, this week I want to take a look at volatility.
WHAT IS IT?
When traders talk of volatility, it is either of the historical or implied kind. Their meanings are exactly that – historical volatility measures how volatile (typically in terms of standard deviation) daily moves in a stock or index have been over a given number of days, while implied volatility is an estimate of how much something will move in the near future.
Most of us are familiar with the VIX indicator, which is an estimation of future volatility derived by computing the relationship among options on the S&P 500 index. As traders position themselves in the options market, the VIX changes on a near real-time basis and the Chicago Board Options Exchange disseminates this calculation to hundreds of data vendors.
WHY SHOULD WE FOLLOW IT?
These measurements and estimations are vital to options traders, as anyone who has been reading Minyanville for any length of time doubtlessly knows by now. So surely anyone considering any kind of trade in the options markets must be familiar with expectations of future movement.
But even those who are looking at plain-vanilla long or short positions should also be watching volatility closely. Unlike stock prices, volatility tends to be mean-reverting, which means that it is, for all practical purposes, bounded by extremes and over a long period of time oscillates around an average value.
Because of that property, volatility can be used to estimate times of sentiment extremes. One needn't use the VIX to judge this, any measure of historical volatility will do. Study long-term volatility cycles, and it will be clear to you that periods of high volatility generally precede strong price rises, and periods of low volatility do not (though that relationship is not as distinct).
WHAT ARE THE CHALLENGES IN USING IT?
There are no hard-and-fast rules for volatility cycles. Obviously, the past few years have shown that volatility can be low and remain that way for a long period of time. But take a very long-term view, and you'll see that our current situation isn't all that unusual – in fact, we go through a multi-year low-volatility period about once every decade. Without fail, however, volatility snaps back.
There are always statements that "this time is different." This time around the culprit is income funds which sell options and suppress volatility. Some also believe that derivatives on the VIX will change how volatility functions in the future.
I don't buy any of it. At some point, uncertainty among traders and investors will increase, prices will rise and fall by more than they do now, and implied volatility will increase along with it. As sure as rain, that uncertainty will reach a fever pitch, we will hear all sorts of arguments about why volatility will always remain high, and soon thereafter it will begin another decline. That's how it has always worked, and how it always will.
WHAT DOES IT LOOK LIKE?
WHAT'S IT SUGGESTING NOW?
Almost exactly three years ago (in terms of trading days), the VIX was trading in the mid-30's as uncertainty reigned regarding a war in Iraq. As those fears faded and fundamentals took over, the S&P 500 rose just over 60% - never suffering more than a 10% correction – and the VIX dropped under to 12.
Of course, I'm describing the past few years. Or maybe not…I could have just as well been writing about 1990 – 1994.
The chart above overlays the past three years against the early 1990's. From the war in Iraq, to the decline in the VIX, to the number of days the S&P went without a 10% correction, the similarities are uncanny.
Soon after the S&P hit its three-year anniversary without suffering a 10% drop, it began its descent into one. The same thing happened in 1965. And 1987. Those are the only three times in the past hundred years I can find where a major index went 756 trading days without a significant decline.
On Wednesday, we will hit day 756. This is a seminal event in my mind, and it will not last. As Jeff Goldblum said in Jurassic Park, "Life will find a way." It certainly will.
So will volatility.
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