 SPX Volatility Trends
Adam Hamilton
Archives
May 7, 2005
Just as a professional fisherman
watches the seas every day and observes much, so do students
of the markets closely following the financial markets day in
and day out. The simple act of observing over time eventually
equips one with a vast mental database of what is normal and
what is not.
Experienced fishermen learn
to read subtle nuances in the ocean and sky that would elude
anyone who does not earn a living on the water. Certain wave
patterns or cloud formations that look unremarkable or benign
to a casual observer may, to a seasoned mariner, portend dangerous
conditions ahead.
Students of the markets are
increasingly noticing a similar subtle, yet potentially important,
anomaly in the US equity markets. Like a small and apparently
unimpressive cumulus cloud peeking over the ocean horizon providing
an initial clue of a storm brewing, the waning volatility in
the stock markets suggests a market storm is approaching.
Volatility, the magnitude of
daily price moves, is like a core pulse underneath the stock
markets. Volatility trends considered over time can offer important
clues as to when markets are oversold and due to rally sharply
or overbought and due to grind or plunge lower. Volatility indirectly
measures the health of a market and the likelihood that an existing
price trend will persist.
The subtle anomaly in today's
US equity markets is the incredibly low levels of volatility.
Largely persisting since the war rally launched in early 2003,
the unnaturally low volatility is surreal and ominous. It is
like a glassy calm sea bereft of wind and waves, it is such an
odd thing that an experienced observer knows it just can't last.
I have been aware of this for
the better part of a couple
of years now, but with each passing month of sub-normal
volatility signatures in the markets it becomes more disturbing.
Since an anomaly is a deviation from normality, the longer it
lasts the higher the probability it will abruptly end. And in
the markets, deviations below normal are almost always followed
by countering deviations above normal, maintaining a stable long-term
average.
Since volatility is so fundamentally
important to discerning probable price trends moving forward,
I have tried approaching it from different angles over the years.
Unfortunately each method of quantifying volatility trends has
drawbacks that limit its usefulness.
For example, raw volatility
data can be graphed using short moving averages to smooth the
enormous day-to-day variability. But the resulting
charts still have such wild volatility lines that they can
be difficult to interpret. Another approach is to use implied
volatility, a hypothetical construct largely based on options
trades that don't really exist. But implied
volatility, in addition to being fabricated, is technically
complex and challenging to understand for those who haven't studied
it.
I've been trying to find an
alternative approach to analyzing volatility that makes it easier
to interpret the data as well as to communicate it to others.
Something that does not require one to be a technician, statistician,
or mathematician to understand. It would also be great if this
approach was so simple that it would be easy to see how any given
market day stacks up against volatility history in real time.
One thesis that may help accomplish
these goals that I have been toying with involves taking discrete
daily volatility benchmarks and viewing them in a kind of frequency
histogram over time. For example, in any given calendar month
what is the total number of days the S&P 500 moves over 1%?
How about 2%+ or 3%+ daily moves?
If we can gain an understanding
of how many 1%+, 2%+, and 3%+ days that the S&P 500 (SPX)
tends to have in a calendar month, and if we chart these over
many years through bull and bear markets alike, then we ought
to be able to discern and measure when volatility is abnormally
low like today or abnormally high like it was in the second half
of 2002. In each case a specific trading strategy based on the
particular volatility extreme is much more likely to yield high
profits.
To make a frequency distribution
of high-volatility market days, one more decision must be made.
Is it best to use interday or intraday volatility?
Interday volatility runs between
days like an interstate highway runs between states. It measures
how much a price moves from its close today to its close tomorrow.
Intraday volatility is within a single trading day like an intranet
is within a single corporation. It quantifies the total move
between a day's high and that same day's low. While doing this
research we built extensive charts for both types of volatility,
comparing them.
Ultimately I chose to use intraday,
same day, volatility as it seemed more pure. It is not uncommon
to have big swings within a trading day while that very same
trading day closes near the previous day's close. Closes can
also be influenced by temporary artificial forces including mutual-fund
window dressing or official intervention to slow sharp slides.
But intraday analysis captures all the true volatility character
that transpires each day regardless of how close to flat the
markets close.
Our first chart this week overlays
the S&P 500 on top of a frequency histogram counting the
number of 1%+, 2%+, and 3%+ intraday volatility days per calendar
month over the past decade or so. This establishes a volatility
fingerprint as a reference point over the secular bull to 2000,
the subsequent secular bear to 2003, and today's two-year old
cyclical bull.
The first thing that leaps
out of this chart is the abnormally low volatility underlying
the US stock markets for the last couple years. The frequency
of 1%+ days per month has shrunk dramatically, the 2%+ days have
become exceedingly rare when they used to be fairly common, and
the big 3%+ days have gone extinct. Students of the markets are
definitely right to perceive today's remarkably placid markets
as an unnatural anomaly.
The second key observation,
while nothing new, is confirmed from this unique analytical perspective.
In general high volatility corresponds to the periodic fear-laden
V-bounces that hammer the markets. So if you are a speculator,
and you see clusters of 3%+ days, odds are the markets are going
to head sharply higher in the immediate future. Conversely low
volatility often coincides with complacency and hence interim
tops.
Since volatility is just a
measure of the magnitude of price movements, it is directly tied
to the forces that drive prices over the short term, greed and
fear. Since greed and fear spawn asymmetrical reactions, it is
not surprising that volatility reacts more strongly to fear.
When people get greedy and complacent they are lulled into a
false sense of confidence and are in no hurry to trade. But when
folks get scared they want to act immediately to assuage their
fears so trading activity jumps dramatically driving price volatility.
Greed and fear as manifested
in average volatility levels can become clearer if considered
across major bull and bear markets. During a bull market greed
is usually higher than fear so general volatility should be lower
on average. During a bear market fear skyrockets so volatility
is much higher as people become more frantic to trade. Since
1996 the S&P 500 has been in a secular bull, a secular bear,
and a cyclical bull so different volatility profiles are readily
available for comparison.
Between January 1996 and March
2000, the bull market top, the S&P 500 witnessed an average
of 14.1 of the 1%+ days, 3.8 of the 2%+ days, and 0.9 of the
3%+ days per calendar month. A calendar month usually runs about
21 trading days in duration, with up to 23 being possible in
31-day months without market holidays. So in the great secular
bull from 1996 to 2000 about 67% of the days witnessed 1%+ intraday
volatility, 18% were 2%+, and 4% saw big 3%+ intraday swings.
From April 2000 to March 2003,
the US stock markets were in a secular bear mode. And, as expected,
heightened fear and uncertainty always increase volatility. This
dark period of time witnessed an average of 18.3 of the 1%+ days,
7.3 of the 2%+ days, and 2.0 of the 3%+ days per calendar month
on average. Thus during the secular bear 87% of market days saw
1%+ daily swings, 35% saw 2%+, and 10% saw the massive 3%+ intraday
moves.
In terms of the larger 2%+
and 3%+ days, the secular bear market was about twice as volatile
as the secular bull market on average. This reinforces the key
market truth that fear spawns volatility. Big price moves are
far more likely to happen when people are scared and frantically
trading than when they are complacent and in no hurry to move
in or out of positions.
Since March 2003, a cyclical
bull market, volatility has been lower as it should be when
prices are rising and investors are happy. But today's volatility
signature is not normal at all. It is far lower than volatility
ought to be in even a bull market in stocks. Something is just
not right as the students of the markets increasingly perceive.
In the past couple years since
the war rally erupted, on average only 10.0 days per calendar
month have witnessed intraday moves greater than 1%. 2%+ days
weighed in at only 0.7 per month while the big 3%+ days have
literally been nonexistent, with an average of zero. Volatility
in the S&P 500, a proxy for the US stock markets as a whole,
is becoming extinct!
Only about 48% of the days showed 1%+ moves, a mere 3% of the
days saw 2%+ moves, and truly big days just didn't happen.
Now today's abnormally low
volatility, even for bull-market conditions, is glaringly evident
when it is compared to the bull market of the late 1990s. Today
1%+ days in the S&P 500 are only 71% as common as they were
leading up to the March 2000 top. 2%+ days since the war rally
erupted in early 2003 are only 18% as common as they were in
the last major bull. And 3%+ days don't even exist anymore!
The implications of these current
volatility trends are quite profound. Volatility is abnormally
low today even for a bull market. But the markets abhor extremes
so it is as unlikely that this eerily low volatility can persist
indefinitely as it is that a patch of the ocean would have no
winds and no waves into perpetuity.
A mean reversion is likely
not only back up to average volatility levels, but probably through
them and beyond into the high volatility realm in order to keep
long-term averages in balance. But high volatility is only common
in fear-laden environments where prices are falling, bear markets.
Today's unsustainable and anomalous volatility doldrums are likely
to yield to coming volatility storms and falling stock prices.
Before we delve further into
this volatility-based market storm forecast, I would like to
present one more chart. It is very similar to the first one above
but instead of showing intraday volatility per calendar month
this one uses a rolling month. Since an average market month
is 21 trading days in duration, we took a moving average centered
on each trading day running 10 trading days into the past and
10 more into the future for 21 total.
The resulting chart shows how
many days in the trading month immediately surrounding a given
day had intraday moves of greater than 1%, 2%, and 3%. Visually
this chart is sharper and more precise in time terms since it
doesn't follow calendar months. Stock markets move when they
want to and their major moves seldom begin or end exactly at
a calendar month end.
I couldn't decide which chart
I liked best for future volatility trend analysis, the square
calendar-month one above or this jagged rolling-month one below
so I threw them both in. I am certainly interested in
hearing feedback on
which chart does a better job of communicating volatility trends
and presents a better base for ongoing future analysis.
This particular rendering of
volatility data visually reinforces the message above, that today's
volatility environment is anomalously low for some reason. It
is not natural and not sustainable, and it is increasingly bothering
more and more students of the markets. Contrarians and mainstreamers,
bulls and bears alike, are rightfully becoming increasingly nervous
of what today's volatility trends portend going forward.
While earnings fundamentals
drive stock markets over the long term, sentiment drives them
over the short and intermediate terms. Popular sentiment swings
perpetually from greed to fear and back again over time like
a giant pendulum. The markets abhor extremes on either side so
widespread greed is always followed by widespread fear and vice
versa.
It is ultimately price movements
that drive sentiment and the magnitude of these movements that
drives volatility. Thus when markets become out of balance in
sentiment terms, either to the greed side near major highs or
fear side near major lows, the only way that balance can be restored
is via price movements going in the opposite direction that will
neutralize prevailing sentiment.
For example in late 2002 the
stock markets had been plunging for months and fear, and hence
volatility, was extraordinarily high. In order for this extreme
negative sentiment to be dissipated, the only course of action
that could bleed off the excessive fear was rising prices. So
stock prices started climbing higher, volatility dropped as speculators
became less agitated, and sentiment balance was restored.
Today we are presented with
the opposite scenario, the other side of the great sentiment
pendulum's arc. Greed and complacency are tremendously high today.
There is no
fear whatsoever in the stock markets so people are in no
hurry to trade, leading to unbelievably low volatility.
Unfortunately the only counterbalance
that can neutralize a greed/complacency sentiment extreme is
falling prices. Whether they fall wickedly sharply to rapidly
stoke a firestorm of fear or they grind lower over many months
to gradually build a crescendo of fear, falling prices are the
only solution to restore balance to sentiment.
These falling prices, since
they scare and unnerve people, also restore balance to volatility
profiles. The more prices fall, the greater the emotional pressure
on investors and the more frantic they become to try to get out
of harm's way. Trading takes on a vastly greater urgency when
prices are generally falling than when they are rising. Falling
prices even affect non-emotional speculators, as they can trigger
trailing stop losses that demand immediate sells.
So the only way today's extremely
low volatility anomaly can be resolved is by falling general
stock prices in the States. Such a plunge or grind lower will
bleed off complacency and increase volatility, gradually restoring
balance to the equity markets.
Now I suspect the degree of
a volatility increase is dependent on the speed with which stock
prices fall and the corresponding ramp up in fear. I am really
curious to see just how high volatility goes in such a scenario.
Will it advance up to the bull-market levels before 2000? Or
will it ramp much higher towards the bear-market levels after
2000?
One of the surest tendencies
of the markets is their propensity to mean revert, to not stay
at any particular extreme for very long in the grand scheme of
things. But a corollary to this ironclad tendency of mean reversion
is the markets' proclivity to overshoot in the opposite direction.
They seldom retreat back to merely average, but they tend to
oscillate between extremes over time.
Thus, there is a good chance
that SPX volatility will increase dramatically, that a volatility
mean reversion driven by falling prices will push the index into
a volatility signature even higher than that of the pre-2000
bull market. Such a volatility overshoot will only be possible
if stock prices fall a lot, not necessarily rapidly, but deep
enough to spawn some real fear for the first time since late
2002/early 2003.
The bottom line is today's
abnormally low volatility, like unnaturally calm seas, is a subtle
warning sign that the markets are now out of balance in sentiment
terms. Complacency is far too great today and a major fall in
stock prices is the only way that balance can be restored. This
will probably drive higher volatility even above that of the
bull market to 2000 on average as this mean reversion overshoots.
At Zeal we are continuing to
closely watch the US stock markets and we periodically layer
in new index options trades as appropriate in our acclaimed Zeal Intelligence
monthly newsletter. We try to search for subtle signs of impending
trend changes that are often only evident to dedicated students
of the markets so we can keep our subscribers
abreast of trading probabilities.
Today's volatility anomaly
is not normal and won't last forever. As it resolves itself probabilities
definitely call for stock price weakness favoring speculations
on the short side. Markets abhor extremes and volatility has
been too low for too long of time. The SPX volatility trends
currently favor far greater volatility moving forward.
Adam Hamilton, CPA
May 6, 2005
Thoughts, comments, or flames? Fire away at zelotes@zealllc.com. Due to my staggering and perpetually increasing e-mail load, I regret that I am not able to respond to comments personally. I will read all messages though and really appreciate your feedback!
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