7 – M2L5 11 Markets & Volatility V3

At this point, you may be wondering, well, what causes volatility anyway? A natural assumption may be that volatility of a stock is caused by new information reaching the market. New information causes people to revise their opinions about the value of a stock. The price of the stock changes which causes volatility. However, research hasn’t supported this conclusion. Research studies have compared the variance of stock price returns between the closing price on one day and the closing price on the next trading day, when there are no non-trading days in between, and the closing price on a Friday and the closing price on a Monday. You might expect the weekend variance to be three times the midweek variance because the real elapsed time is three times as long. However, this has not been found to be the case, even for assets affected by news that is equally likely to arrive midweek or on a weekend. The weekend variants of orange juice futures prices which are mainly affected by weather news is only about 1.5 times the midweek variance. The implication of all this is that volatility is, to a large extent, caused by trading itself. This idea is consistent with the observation that volatility and volume are frequently correlated. All other things being equal, greater trading volume means greater volatility. But during a time when volatility is high because lots of trading is happening and the price goes up, you might reasonably expect the price to go back down. If there was no news, the price probably didn’t increase because the company’s performance improved. It probably increased because people wanted to trade large numbers of stocks and sellers charged a premium for that ability to trade, or liquidity. This means that for equity strategies in high volatility times, a type of strategy considered more likely to do well is a type of strategy based on the idea that prices will return to their running mean when they go way up or down. These are called mean reversion strategies. In low volatility times, momentum strategies may work better. There are other general patterns in market behavior with respect to volatility. One is that market volatility tends to be high when the market is going down and low when the market is going up. Because of this, volatility is often quoted in the popular media as the gauge for fear. To see this most clearly, let’s look at an index that essentially measures market volatility. You might have heard of the VIX Index, which is a market index measuring the volatility of 30-day S&P 500 Index options. The value of the VIX index represents the annualized volatility of the S&P 500 Index. This plot of the VIX Index and S&P 500 Index over the same periods shows that the VIX spikes when the S&P dips. For example, between 1990 and 2015, VIX spiked to a record 80 during October and November of 2008 when, as you remember, the markets were roiling from a huge crisis. I know what you’re thinking, can you trade the VIX itself? You guessed it. Humans will turn anything into tradeable securities. You can trade futures and options on the VIX Index which essentially amounts to making a bet on the volatility of the S&P 500. The VIX is published by the Chicago Board Options Exchange, which publishes a range of other volatility indices on stock and commodity indices currencies and some individual stocks. There’s even a Volatility Index of the VIX Index, the VVIX.

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