The longer that I study the financial markets, the more convinced I become that volatility is one of the most important factors for investors and speculators to carefully consider before executing trades.
While there are countless trading indicators out there with varying degrees of effectiveness, volatility constantly seems to rise near the top of the heap. Volatility is simple and effective, and remarkably consistent throughout the vast majority of financial-market history.
I suspect that volatility is such a telltale indicator for speculators because it ties in so intimately with human emotions. Ultimately the ancient mortal emotions of greed and fear are what truly drive the financial markets over the short-term, but of course these can't be empirically quantified. Volatility, however, so closely follows popular greed and fear that it is one of the best proxies around for these ethereal emotions.
The concept of volatility is very easy to understand, as it simply expresses how violently prices happen to be bouncing around. Low volatility is defined as small moves in prices over a short period of time, such as a single trading day. High volatility describes the opposite condition, large price moves over a similarly small slice of time. Naturally the giant swings of high volatility are significantly rarer than the lethargic low volatility conditions.
Volatility closely mirrors general greed and fear like a shadow since we eminently predictable human traders tend to always react the same way when we collectively grow either too greedy or too scared.
During times of widespread greed, all of us speculators have the natural tendency to grow complacent and happy. Prices are either marching up or already relatively high, often we are blessed with nice unrealized profits riding on the uptrend, and general nervousness and anxiety are low. During these fun times traders' spirits are up and the future looks dazzlingly bright, so general trading volume wanes to anemic levels.
With the majority of speculators fat and happy without a worry in the world, the urge to trade is minimal and prices don't move around much. This is why low volatility and popular complacency and greed go hand in hand. While it is important to realize that greed and complacency cause low volatility and not the other way around, the low volatility, trivial price movements, is an important sign betraying widespread greed under the surface.
Conversely when we speculators collectively grow scared, we vastly ramp up our trading volume. Fear is a much more powerful emotion than greed, and it acts far more quickly as well. In times of perceived danger, the instinct of self preservation is infinitely stronger than the desire for growing capital. An old financial parable about free gold coins and a nasty gorilla helps to illustrate this point.
If you are walking down the street and someone throws hundreds of gold coins into the air, after pondering a short time your natural instinct is to dive and grab as much of the free gold as you can. Greed! But if the same valuable coins are thrown into the air and land at the feet of a rabid 800lb gorilla wielding a wicked straight razor, your natural instinct is to run like mad. Fear! And you don't have to think about fear, the response is instant and the need to flee is overwhelming. Greed festers over time, but fear ramps up to unbearable levels in a heartbeat.
When traders are steeped in general fear, our natural human instinct is to sell as quickly as we can to limit our exposure. Run for the doors, sell now, get your capital safely out of harm's way, and only then stop to assess the situation from the outside. Naturally virtually everyone feels this way at once though, so the selling spawned by fear rapidly feeds on itself and leads to large price movements over short periods of time, high volatility.
Greed and complacency lead to lower trading volumes and smaller price movements, while fear begets higher trading volumes and larger price movements. And while we cannot measure greed and fear directly, we can measure the resulting price movements and use this volatility information to extrapolate back to what the popular prevailing emotions at any given time appear to be.
While the incredibly useful and highly popular implied volatility indices like the S&P 500's VIX seek to quantify theoretical options volatility 30 calendar days into the future, they are not the only measure of volatility. I am a huge fan of implied volatility and use it often in my own speculations and analysis, but it is not actual volatility and must be recognized as a synthetic measure. Actual volatility can offer additional insights that implied volatility cannot.
While implied volatility requires sophisticated math to calculate, actual volatility is very simple. There are really two primary measures of actual volatility, interday and intraday. Naturally interday volatility expresses the degree of price changes from one trading day to the next, while intraday volatility quantifies volatility within any single trading day.
As I am positive that all index speculators have observed in recent months, the price movements in the Big Three US stock indices have seemed incredibly small lately. I have been wondering for a while now whether this low volatility that we are experiencing these days is normal or exceptional, a rare event worthy of note.
In order to investigate, this week we calculated and graphed the interday and intraday volatility numbers on the mighty S&P 500. The results of this research were quite illuminating and offer some striking evidence for the most probable near-term course for the major US indices.
Our first graph this week shows the S&P 500 superimposed over its own interday volatility. Interday volatility is calculated by subtracting yesterday's S&P 500 (SPX) close from today's close and dividing the difference by yesterday's close. The result is the day-to-day percentage change in the flagship index. Finally, to make all of the raw interday volatility numbers positive and comparable, an absolute value is applied to change any negative numbers into positive numbers. Volatility analysis is not concerned with whether a market moved up or down on any given day, but only with how far it moved.
As you would expect, the raw volatility numbers are all over the map. It is not uncommon to see a very low volatility day followed by a very high volatility day. These raw numbers are graphed in dark gray below for visual reference. In order to distill down this chaotic raw data into more useable trends, we applied a short 10-day-moving average to the raw numbers, which is rendered in red below. This interday volatility 10dma is really interesting and offers a lot of valuable insights to investors and speculators.
Just as volatility theory suggests, low volatility corresponds with times of general greed and complacency near interim market tops while high volatility is witnessed during periods of general fear around interim market bottoms. Traders are euphoric when the markets are up and they trade less as they bask in the glow of winning, but when the markets fall they rapidly grow scared and sell like crazy catapulting up volatility.
It always strikes me as ironic that no matter how advanced trading becomes, no matter how much computational power we throw at the markets, it all ultimately boils down to greed and fear. As long as any humans are in the trading loop anywhere, and we always will be, our own emotions dominate the short-term markets.
As you examine the graph above, note that the red absolute interday volatility 10dma line seems to generally hover around 1% or so. The actual average of the almost four years shown above is 0.94%, just slightly under 1%. I find this 1% number interesting because in my opinion the markets are "unchanged" on any given trading day unless they move by more than 1% in either direction. Anything under 1% in isolation seems to be random noise, not really helpful to trading. The average volatility is just under this threshold of randomness.
But when the volatility trends are observed over time, the single-day randomness falls away and very tradable patterns emerge. Index speculators really ought to consider the state of general market volatility before they launch any significant short-term trades.
For example, when the interday volatility 10dma is above its 1% average, it generally means the markets are either falling or have just emerged from downtrends. And if you go up to 1.5%, every occurrence of these levels in the past few years or so marked a period of time of popular fear and selling, when traders were liquidating positions and getting out of Dodge as black fear relentlessly grew and festered.
While these high-volatility episodes marking popular fear are fascinating to study, they are not as relevant at the moment today as the times when the interday volatility 10dma heads significantly under its 1% average. As you can see above, the red-shaded area surrounding 0.5% interday volatility seems to be close to the hard floor in 10dma terms since 2000. While the interday volatility 10dma has briefly kissed 0.5% nine times since 2000, it has never lingered at such extraordinarily low levels for long.
In just the past couple months this extremely low 0.5% level has been hit twice, which empirically confirms the suspicions that many speculators including I had about the incredible lack of volatility today. Volatility didn't only feel unnaturally low in recent weeks, it was unnaturally low! And such extreme levels of volatility scarceness, or volatility extinctions, are telltale signs of widespread popular greed and complacency.
Every time the absolute interday volatility 10dma of the S&P 500 sliced under 0.5% or so in the past several years, it marked moments in time when the markets were topping and on the verge of substantial falls. The yellow arrows on the graph above line up the volatility lows with the corresponding points in time in the S&P 500. No matter where you look, such volatility extinctions heralded either actual interim tops or interim topping processes, times when the US markets were at or close to the highest levels that they would achieve in each particular rally.
Even more provocatively, in late August the interday volatility 10dma of the SPX slid to 0.37%, its lowest point in the entire graph above! Volatility truly is nearing extinction when average interday index changes plunge down to only about 1/3rd of one percent over a couple of weeks, really extraordinary stuff! Even at the very first volatility extinction graphed above, exactly three years earlier to the week in August 2000, the volatility 10dma only fell to 0.39%. This was within mere days before the Great Bear in this flagship American equity index began. Déjà vu?
Everywhere you look in the chart above, the extremely low volatility extinctions around 0.5% marked a point in market history when an S&P 500 selloff was either imminent or soon approaching. The extreme popular greed and complacency levels necessary to drive volatility so abnormally low are only witnessed near major interim tops, when the vast majority of folks are overwhelmingly bullish and simply lack all fear of a pullback or selloff.
The recent anomalously low volatility in the US equity markets is confirmed by the S&P 500's intraday volatility, or its total percentage trading range within any individual day. This number is computed by subtracting a given day's low from its high and dividing the difference by this same day's close. As this result is always positive, no absolute valuing is necessary for intraday volatility calculations.
While the interday numbers above showed us that the SPX day-to-day volatility has been extraordinarily low recently, near extinction, this startling conclusion is also strongly confirmed by the intraday numbers shown below. Volatility is as abnormally low within individual trading days as it is between trading days, certainly an ominous portent for the near-future performance of the US equity markets.
Intraday volatility within single trading days is generally larger than interday volatility from day-to-day, so it is not surprising that the average of this data series is quite a bit higher at 1.6% or so. Once again low intraday volatility marks times when the markets are topping, when widespread greed and complacency leads to lower trading volume and smaller price movements.
In intraday volatility 10dma terms, 1.0% or so seems to be the hard floor in recent years. The red 10dma of intraday volatility has only touched or pierced 1% a half dozen times since 2000, with two of these events in recent months. Prior to 2003, just like in interday volatility above, such intraday volatility extinctions marked moments in time when the markets were topping immediately or soon before a major selloff.
Today's episode of abnormally low volatility is even more evident in these intraday terms. Never before in this Great Bear has intraday volatility's 10dma hovered around rock-bottom 1% levels for so long. In terms of the dark gray raw data, the single day spikes approaching 0.5%, extraordinarily low, have been even more frequent in recent months than at any other time since early 2002 right before one of the most wicked waterfall declines in this entire bear market to date. These single-day evaporations of volatility are circled in yellow above.
Index speculators really should pay careful attention to these volatility extinctions. When greed and complacency become so incredibly popular that volatility can plummet to such extraordinary and abnormal lows, odds are that the bear-market rallies that spawned these volatility lows have about reached the ends of their lifespans. Only when practically everyone is bullish and the rally is already essentially over can the actual volatility numbers be shoved so mercilessly low. This is very clear on the charts above.
Now contrarian speculation theory, of course, states that speculators need to throw long when others are scared and throw short when others are greedy. The great thundering herd of the crowd is always wrong at the turning points. They are the most bearish and pessimistic at the sharp V-bounces like last October, and they are most bullish and optimistic at the lazy low-volatility interim tops like today. The prudent contrarian speculator will bet against the crowd at the turning points, which is certainly where we appear to be today.
The volatility extinctions, which are quantifiable mathematical proxies for the rampant greed that ultra-low raw volatility closely shadows, only happen near interim market tops in recent market history! Odds are that the current bear-market rally or cyclical bull, depending on how you want to classify it, is effectively over since the recent hard floors in both SPX interday and intraday volatility 10dmas are being actively challenged.
Extreme greed and complacency was never sustainable in the past, witness March 2000 which we all remember well, and it certainly won't be infinitely sustainable this time. With the "all bullish all the time" newsflow and extraordinarily low volatility, contrarian speculators ought to get ahead of the crowd and be preparing to launch their next short-side trades.
At Zeal we have been eagerly awaiting the end of the war-rally bullish euphoria and the return of the cold realization of the ugly realities of the vastly overvalued US equity markets. In both our Zeal Intelligence monthly newsletter and Zeal Speculator alert service I have been outlining how we are planning on trading this coming selloff.
I have discussed how we are going to play the downleg, when we are going to launch our trades, what indicators we are using to make these specific timing decisions, what technical signals you can look for, and exactly how to follow along at home and play this grand game. And when the moment comes to pull the trigger and load up on put options for the coming mean reversion from extreme greed back to fear, I will also recommend the same trades that we actually end up executing ourselves in our own accounts.
Please consider subscribing today if you are interested in seeing how we apply the research I articulate in these weekly essays into real-world index-options trades in the weeks and months ahead!
The bottom line is that the S&P 500 volatility extinctions that we are witnessing these days, just as in the past years, are heralding a big move coming in the US stock markets. Contrary to all the widespread euphoria and predictions of a new secular bull market, the volatility is desperately trying to signal that this next major move will be down, quite probably hard.
While this coming highly probable waterfall decline will slaughter the perma-bulls as usual, prudent contrarian speculators can get out ahead of this beast and gain a shot at earning truly legendary profits on the short side. The subtle SPX volatility extinction warnings are far too important to ignore.
Extreme greed which spawns extremely low volatility was never sustainable in the past, and odds are that it will certainly not be sustainable this time around either. Get ready!