A Long Term View On….Volatility
- Posted by Greg Harmon
- on December 26th, 2012
Volatility: A statistical measure of the dispersion of returns for a given security or market index. Volatility can either be measured by using the standard deviation or variance between returns from that same security or market index.
The words, bad, loss and fear do not show up in this definition from Investopedia. So why is the Volatility Index, $VIX, referred to as the Fear Gauge? And what are you supposed to be afraid of anyway? The daily chart of the VIX for 2012 below shows it traded in a tight range between 13.30 and 27.73. Sure it looks like a monster spike in May but remember that as a statistically derived gauge it cannot go below 0 and is difficult to get below 10, but can rise infinitely. From that perspective 13.30-27.75 is a very low range. And as my friend Adam Warner has pointed out many times this year, it has been overstating the volatility of the market. There has been no fear in the Fear Index in 2012. A closer look at this chart does identify some interesting information though.
Heading into the end of the year all of the Simple Moving Averages (SMA) have converged into a very tight range between 16.10 and 17.43. There was also a trend higher in the Relative Strength Index (RSI) that has turned from support to resistance in the last month. These signs of complacency may forebode more of the same in the future, or the compressed spring preparing to explode. Moving to broader weekly picture below shows that this mellow range is in fact an elevated range compared to the 2005 through 2007 period. Also that the bulk of the time since 2007 the VIX has been within the 15-25 range. The forays above 25 have all been preceded by the RSI on the
weekly chart breaking the range higher and the moving Average Convergence Divergence histogram (MACD) moving to positive or also moving out of a range. There have been warnings. There are no warning signals at the moment but the possibility is there. It is in looking at the monthly chart that gives some perspective. Very near the current levels has been the dividing line between relatively high or low risk environments. The correlation to the S&P 500 also becomes apparent. The spike in the VIX in 2008 coincided with the stock market crash. During the long bull run from 2003 through 2007 the VIX was low and falling. But during the 1995 to 1999 bull run the VIX was elevated and rising. So a rising VIX does not necessarily mean falling equity prices. There is one additional pieces of information that can be gleaned from this chart. First the period from
2000 to 2003 shows that it was not a spike in volatility that should be feared but a spike in the volatility of volatility. That is not present today. What does all this mean? Several things. First, if you want to hedge your portfolio risk by buying the VIX you are likely gambling with no real edge. Sell S&P Futures or buy S&P Puts instead. Second, the VIX is low, but it can get and stay a lot lower. Just because it is in the teens does not mean the next move is higher. Third, there is no clear future direction jumping out of these charts so expect more of the going into 2013.
This is the ninth in a series of A Long Term View On …. articles.
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Gregory W. Harmon CMT, CFA, has traded in the Securities markets since 1986. He has held senior positions including Head of Global Trading, Head of Product Development, Head of Strategy and Director of Equity. (More)
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