fsu editorials

VOLATILITY AS A STOCK MARKET INDICATOR
by Hans Wagner
TradingOnlineMarkets.com
August 27, 2007

Investors seeking to beat the stock market are always looking for a way to help predict the trends that lead to profits. The movements up and down create opportunities for investors and traders. They also create serious risks and can cause investors to panic and sell at the wrong time. Knowing how use this volatility can help investors improve their performance.

What is Volatility?

Volatility is a measure of dispersion around the mean or average return of a security. While there are several ways to measure volatility one of the most common is to use the statistical measure called the standard deviation. A standard deviation tells an observer of a stock or index how tightly grouped it is around an average, such as the moving average. A small standard deviation means the price is tightly bunched together. A large standard deviation means the price is spread apart.

For securities, the higher the standard deviation, the greater the dispersion of returns and the higher the risk associated with that investment. As described by the Modern Portfolio Theory, volatility creates risk that is associated with the degree of dispersion of returns around the average. The greater the dispersion is from the average, the riskier the investment.

Another way to measure volatility is to take the average range for each period, from the low price value to the high price value. This range is then expressed as a percentage of the beginning of the period. Larger movements in price creating a higher price range results in higher volatility. Lower price ranges result in lower volatility.

Volatility and Market Performance

A number of studies have shown that when volatility rises, there is a greater chance that the stock market is experiencing losses. Basically, when the stock market is climbing, volatility tends to decline. On the other hand when the stock market falls, volatility tends to rise.

Ed Easterling of Crestmont Research studied the relationship between the volatility of the stock market and the performance of the S&P 500. His analysis showed that lower volatility corresponds to a higher probability of a rising market. As shown in the table below, when the average daily range in the S&P 500 index is low (the first quartile 0% - 1.0%) the odds are high, about 70% monthly and 91% annually that investors will enjoy gains of 1.3% monthly and 12.9% annually.

When the average daily range moves up to the fourth quartile (1.8% - 2.6%), there is a probability of a -0.4% loss for the month and a -4.1% loss for the year. The effects of volatility and risk are consistent across the spectrum. When volatility increases, the risk of lower returns also increases. You can read more about Ed�s research in his book Unexpected Returns: Understanding Secular Stock Market Cycles.

Relationship of Volatility and Market Returns

(S&P 500 Index: 1962 � January 31, 2007)

MonthlyData: S&P 500 Index Average Daily Range

Quartile

VolatilityRange

%ChanceUp Month

%Chance Dn Month

IfUp Avg Gain

IfDown Avg Loss

ExpectedGain/(Loss)

1st

0%- 1.0%

70%

30%

2.7%

-1.8%

1.3%

2nd

1.0%-1.4%

61%

39%

3.1%

-2.2%

1.0%

3rd

1.4-1.8%

59%

41%

3.1%

-3.1%

0.6%

4th

1.8%-2.6%

44%

56%

5.0%

-4.6%

-0.4%

AnnualData (1962 � 2006): S&P 500 Index Average Daily Range

Quartile

VolatilityRange

%ChanceUp Month

%Chance Dn Month

IfUp Avg Gain

IfDown Avg Loss

ExpectedGain/(Loss)

1st

0%- 1.0%

91%

9%

14.3%

-1.5%

12.9%

2nd

1.0%-1.4%

82%

18%

19.1%

-9.0%

14.0%

3rd

1.4-1.8%

82%

18%

15.6%

-11.6%

10.6%

4th

1.8%-2.6%

42%

58%

13.4%

-16.6%

-4.1%

Source:Crestmont Research (www.CrestmontResearch.com)

These findings indicate investors need to be more aware of the volatility in the market as they make their buy and sell decisions.

Measuring Market Volatility

Many investors use the Chicago Board Options Exchange (CBOE) Volatility Index (VIX) to measure volatility of the market. The VIX measures the implied volatility in the prices of a basket of put and call options on the S&P 500 index. A high reading on the VIX marks periods of higher stock market volatility. This high volatility also aligns with stock market bottoms. Low readings on the VIX mark periods of lower volatility. The only problem is the periods of low volatility can last for several years, so it is not as good at identifying market tops. The VIX is intended to be forward looking; measuring the market's expected of volatility over the next 30 days. Often the VIX is referred to as the �fear index.�

The CBOE provides a wealth of data on the performance of the VIX and other indexes, especially the S&P 500. It is a good place to go to get an idea of the long term perspective of the VIX. The chart below, from the CBOE site, shows the VIX and the S&P 500 since August 2001. Notice how when the VIX is rising as the S&P 500 falls. Also, when the VIX is at a high, the S&P 500 is at a low, a good place to buy. The problem investors will face when the VIX is high is that there is normally a high level of concern that the market is going to continue to go down. This fear is what makes it difficult to buy during these times of high stock market volatility. Yet those investors who used the high on the VIX to time their buys entered the market at or very near an important low.

Source: CBOE VIX Price Charts

Given this brief analysis, the VIX is useful to help investors identify to enter the market based on high volatility. It is less useful to help investors to identify when the market is at or near a top. You can also see a current version of the three year weekly VIX chart with annotations on the Premium Members pages of Trading Online Markets.

Crestmont Research also publishes a chart of their research on the volatility of the S&P 500. This chart shows the three month moving average of the average daily range of the S&P 500 Index. When the moving average is below the median of 1.4% the market is experiencing low volatility. Above the median of 1.4% volatility is increasing or at a high level. Investors interested in viewing this chart should go to Crestmont�s site.

Crestmont�s chart of volatility also works well to help identify market bottoms based on high volatility. For long term investors, it also does a pretty good job of helping investors identify that the stock market is at or near a top, when volatility is very low. Keep in mind this indicator is not intended to time the exact top, but rather that the volatility of the market does not stay substantially below the mean for long period of time. As the volatility increases, then the market's performance will tend to decrease.

The Bottom Line

Higher volatility adds to the level of worry by investors as they watch the value of their portfolios move violently and decrease in value. Unfortunately, this volatility can cause investors to respond irrationally, selling when the price of the shares have fallen to a low. Knowing how to use volatility to your advantage can help investors make rational decision on when to buy and when to sell stocks.

© 2007 Hans Wagner
Editorial Archive

As a long time investor, I was fortunate to retire at 55. I believe you can employ simple investment principles to find and evaluate companies before committing one's hard earned money. Recently, after my children and their friends graduated from college, I found my self helping them to learn about the stock market and investing in stocks. As a result I created a website that provides a growing set of information on many investing topics along with sample portfolios that consistently beat the market. Feel free to visit the site at http://www.tradingonlinemarkets.com/

Contact Information
Hans Wagner

tradingonlinemarkets.com
Manitou Springs, CO USA
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