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As markets shed billions, traders welcome return of volatility

So says this piece in the Fairfax press this morning. The headline contains two interesting assumptions. That the market has become more volatile and that this volatility leads to the potential for profit. I will state at the outset that the linkage between profit and volatility that is often asserted by both some members of the finance community and the financial press at large is wrong – no such nexus exists. It is based upon a profound misunderstanding between trend and volatility. Volatility is simply the speed and magnitude of price movements, there is no directional component  implied in any statement about volatility. Trend is the capacity of price to demonstrate an underlying direction on price distribution.

The first statement about the return of volatility is an easy one to look at. In this instance the volatility measure being referred to is the somewhat flawed marker the VIX. The chart below shows a spike in the VIX when the ginger gibbon Donald Trumps month went from bad to worse.

VIX

However, on this chart I have plotted the long term average daily value for the VIX, at present this long term average stands at 20.1. The market is still substantially below this figure and as can be seen from the chart the VIX is prone to short lived spikes. These spikes are inevitable because at its core the VIX is a measure of perception and perception is a uniquely flawed mechanism for generating any form of metric. You can think of the VIX as a sort of how do you feel today index. As such it is prone to all sorts of maladies just like an individual is.

The question of whether an increase in volatility is a good thing is an interesting question and it is the one which often demonstrates peoples misunderstanding of volatility. The chart below focuses on the period 2003 to 2008 so it encompasses the US markets rise post the Dot com boom and the resultant carnage of the GFC.

vix comparison

The central theme is that high volatility leads to an increase in opportunity and therefore an increase in traders profitability. On the chart above I have marked the average volatility for the period 2003 to 2008, which for this period sat at 16.1. As can be seen for the majority of the period the VIX sat at below its long term volatility. During this period the market more than doubled. Low volatility is not an anathema to the potential for profit, the inability of the market to establish a trend is of more of a concern for traders.

Markets Are Moving

I posted this in the Mentor Program forum this morning and it is worth sharing because it represents my favourite style of price distribution. This one week relative performance is reminiscent of a smile and it indicates a series of movements that provide ample opportunity for traders. I accept that parts of equities markets are stuffed and if you are restricted to those then your opportunities will be limited.  Remember – equity markets are the smallest markets in the world.

Capture

Are We Scared Yet?

Apparently, the world is ending because the media says so. The source of much of this hysteria is that the media seemed to have discovered a tool known as the S&P/ASX200 VIX indicator which is also known as the fear indicator. One somewhat hysterical report claimed that it was the highest it had ever been, which it is not. What they saw was obviously the ASX chart that only goes back to 2012. Punters will know that I have mixed feelings about volatility based tools. I tend to regard them in much the same way that General George S Patton regarded the French Resistance. Not as good as advertised but better than expected.  There are two things that are important when looking at volatility based tools, particularly those that are based upon implied volatilities such as VIX in all its domestic forms.

The first thing we need to be aware of is basic context – volatilities are relative values so whilst a number might sound high in isolation, context might provide a slightly more nuanced view. Consider the chart below of the S&P/ASX200 with a 30 period historical volatility plotted.

Screen Shot 2015-09-04 at 10.00.37 am

In the indicator box I have plotted two lines. The unbroken blue line represents the average historical volatility for all the data on the chart whereas the broken line represents average historical volatility since the GFC. This tells us an interesting story – volatility in terms of is historical volatility is not that bad. In fact it is sitting below the average volatility of the market post the GFC. This of course comes with all the caveats that using simple averages come with, nonetheless it is an interesting picture. This raises the question of why the hysteria over volatility and I think the answer to that is found in the age old problem that people confuse trend with volatility. The belief being that if the market is going down then it must be more volatile. Unfortunately, this is the default narrative of talking heads in the media.

The picture is slightly different when we look at the local version of the VIX over the long term.

Screen Shot 2015-09-04 at 10.00.17 am

The solid read line represents the average for the entire data set whereas the broken line represents the average since the GFC. The picture with the local VIX is a little different to that of the underlying index with its historical volatility plotted. The reason for this difference brings me to my second important point when viewing such tools. When you look at the VIX you are seeing the markets expectation of volatility over the next 30 days based upon a blended average of expectations generated from index option prices. So you are seeing in effect an opinion about what volatility might be in the near future. However, this opinion is based upon the past and is an attempt to project into the future. In its most basic form there is nothing wrong with this because this is how we all construct our views of the market. The issue I have with this is the near quasi religious status that such tools have and the belief that somehow they predict the future of the market. What they offer is an expression of opinion about volatility not trend and if you look at the historical distribution of prices you see that the VIX rises after an event – not before it. It has to be this way, if volatility rose before any change in the underlying you would have problems with the notion of cause and effect.

This raises issues for the average punter because they are being bombarded by somewhat breathless pronouncements about the level of fear in the market. The easiest solution is isolation and ignorance. It is all too easy to be swept up in the overthinking and prognostication that goes on when markets begin to move. This is simply noise. Noise is in many ways a function of volatility – the more markets move in a short period of time the noisier they become. From my perspective noise is a common crowd response to activity and can be compared to what happens a sporting events. As the action increases so too does the volume of the crowd. This increase in volume produces a series of emotional responses in the crowd. These responses are generally always subconscious – people when influenced by crowds often do things for which they have no rational explanation. The same is true in trading.

As the Japanese are fond of saying. To take no action is an action. Unfortunately, traders believe somewhat falsely they must always being doing something, even if it is the wrong thing.

Well….Somebody Woke Up

Screen Shot 2015-08-21 at 6.21.45 am

And Now Something About Volatility.

Here is a news flash for. Nobody in the financial media has any understanding of volatility at all – if you are surprised then you probably shouldn’t be trading.  Much of the talk surrounding the issues with Greece have centred around how volatile markets have become, these statements are made without even understanding what volatility is let along whether they have become more volatile. There is a presumption ( and this is made by traders too ) that price movement or trend is volatility – it is not, the two are very distinct and to confuse the two is to confirm your status as a peanut. Consider the chart below which is of the VIX – a default standard for volatility within the US market.

Screen Shot 2015-07-01 at 4.01.35 pm

The red line is the average volatility for the past decade – yep its a quick an dirty measure that is somewhat distorted by the GFC. However, excluding the GFC and just taking the last five years gives me a figure of 18.1%, so volatility at present is about average.

Long Term VIX

I thought it might be a bit of fun to look at the VIX and the S&P 500 over the longer term.

Screen Shot 2015-01-29 at 9.02.54 pm

Risk & Volatility Index Dashboard

I regularly get emailed things from S&P Dow Jones Indices – most it relates to index structure, performance or changes. Some of it is data for data sakes with no real use, but some bits are interesting from a summary perspective. I have always had mixed views about volatility and have spoken about it a few times see here and here My views are mixed because it is perennially misunderstood and it is used as an attempt to predict where markets are going. Both are irritating mistakes made by amateurs who claim to be professional.

The interesting thing about volatility is that it displays wonderful mean reversion and this is a point made tangentially by S&P when they talk about volatility returning to markets.

The VIX® returned to levels not seen in several years, breaking through 30 intraday on October 15th before falling back to close yesterday at 17.87. Both rise and fall in the VIX were precipitous and, despite returning to more normal levels, the market remains skittish.

Markets have experienced periods of extended low volatility which would eventually end. The image below is of a selection of world indices with 30 HV and a 250 day MA plotted. The 250 day MA approximates the long term average volatility of each market. As you can see the rise in volatility was not universal with some markets continued to trend but doing so with only a minor increase in volatility.

Screen Shot 2014-10-24 at 12.13.51 pm

(Click image for a large version)

There does however remain a central question with such data – what do you do with it and how does it affect your trading decision? For me it actually has little relevance outside of academic interest. That is not to say that I regard volatility as an irrelevancy in trading because it isn’t. I use volatility for bet sizing and for trade selection. Beyond that I feel its actual utility is limited for the majority of traders.

General Advice Warning

The Trading Game Pty Ltd (ACN: 099 576 253) is an AFSL holder (Licence no: 468163). This information is correct at the time of publishing and may not be reproduced without formal permission. It is of a general nature and does not take into account your objectives, financial situation or needs. Before acting on any of the information you should consider its appropriateness, having regard to your own objectives, financial situation and needs.