Best of the Week
Most Popular
1. Stock Markets and the History Chart of the End of the World (With Presidential Cycles) - 28th Aug 20
2.Google, Apple, Amazon, Facebook... AI Tech Stocks Buying Levels and Valuations Q3 2020 - 31st Aug 20
3.The Inflation Mega-trend is Going Hyper! - 11th Sep 20
4.Is this the End of Capitalism? - 13th Sep 20
5.What's Driving Gold, Silver and What's Next? - 3rd Sep 20
6.QE4EVER! - 9th Sep 20
7.Gold Price Trend Forecast Analysis - Part1 - 7th Sep 20
8.The Fed May “Cause” The Next Stock Market Crash - 3rd Sep 20
9.Bitcoin Price Crash - You Will be Suprised What Happens Next - 7th Sep 20
10.NVIDIA Stock Price Soars on RTX 3000 Cornering the GPU Market for next 2 years! - 3rd Sep 20
Last 7 days
Trump and Coronavirus Pandemic Final US Catastrophe 2021 - 19th Jan 21
How To Find Market Momentum Trades for Explosive Gains - 19th Jan 21
Cryptos: 5 Simple Strategies to Catch the Next Opportunity - 19th Jan 21
Who Will NEXT Be Removed from the Internet? - 19th Jan 21
This Small Company Could Revolutionize The Trillion-Dollar Drug Sector - 19th Jan 21
Gold/SPX Ratio and the Gold Stock Case - 18th Jan 21
More Stock Market Speculative Signs, Energy Rebound, Commodities Breakout - 18th Jan 21
Higher Yields Hit Gold Price, But for How Long? - 18th Jan 21
Some Basic Facts About Forex Trading - 18th Jan 21
Custom Build PC 2021 - Ryzen 5950x, RTX 3080, 64gb DDR4 Specs - Scan Computers 3SX Order Day 11 - 17th Jan 21
UK Car MOT Covid-19 Lockdown Extension 2021 - 17th Jan 21
Why Nvidia Is My “Slam Dunk” Stock Investment for the Decade - 16th Jan 21
Three Financial Markets Price Drivers in a Globalized World - 16th Jan 21
Sheffield Turns Coronavirus Tide, Covid-19 Infections Half Rest of England, implies Fast Pandemic Recovery - 16th Jan 21
Covid and Democrat Blue Wave Beats Gold - 15th Jan 21
On Regime Change, Reputations, the Markets, and Gold and Silver - 15th Jan 21
US Coronavirus Pandemic Final Catastrophe 2021 - 15th Jan 21
The World’s Next Great Onshore Oil Discovery Could Be Here - 15th Jan 21
UK Coronavirus Final Pandemic Catastrophe 2021 - 14th Jan 21
Here's Why Blind Contrarianism Investing Failed in 2020 - 14th Jan 21
US Yield Curve Relentlessly Steepens, Whilst Gold Price Builds a Handle - 14th Jan 21
NEW UK MOT Extensions or has my Car Plate Been Cloned? - 14th Jan 21
How to Save Money While Decorating Your First House - 14th Jan 21
Car Number Plate Cloned Detective Work - PY16 JXV - 14th Jan 21
Big Oil Missed This, Now It Could Be Worth Billions - 14th Jan 21
Are you a Forex trader who needs a bank account? We have the solution! - 14th Jan 21
Finetero Review – Accurate and Efficient Stock Trading Services? - 14th Jan 21
Gold Price Big Picture Trend Forecast 2021 - 13th Jan 21
Are Covid Lockdowns Bullish or Bearish for Stocks? FTSE 100 in Focus - 13th Jan 21
CONgress "Insurrection" Is Just the Latest False Flag Event from the Globalists - 13th Jan 21
Reflation Trade Heating Up - 13th Jan 21
The Most Important Oil Find Of The Next Decade Could Be Here - 13th Jan 21
Work From Home £10,000 Office Tour – Workspace + Desk Setup 2021 Top Tips - 12th Jan 21
Collect a Bitcoin Dividend Without Owning the King of Cryptos - 12th Jan 21
The BAN Hotlist trade setups show incredible success at the start of 2021, learn how you can too! - 12th Jan 21
Stocks, Bitcoin, Gold – How Much Are They Worth? - 12th Jan 21
SPX Short-term Top Imminent - 12th Jan 21
Is This The Most Exciting Oil Play Of 2021? - 12th Jan 21
Why 2021 Will Be the Year Self-Driving Cars Go Mainstream - 11th Jan 21
Gold Began 2021 With a Bang, Only to Plunge - 11th Jan 21
How to Test Your GPU Temperatures - Running Too Hot - GTX 1650 - Overclockers UK - 11th Jan 21
Life Lesson - The Early Bird Catches the Worm - 11th Jan 21
Precious Metals rally early in 2021 - 11th Jan 21
The Most Exciting Oil Stock For 2021 - 11th Jan 21
Financial Market Forecasts 2021: Navigation in Uncharted Waters - 10th Jan 21
An Urgent Message to All Conservatives, Right-Wingers and Patriots - 10th Jan 21
Despite Signs to the Contrary, Gold Price at or Near Top - 10th Jan 21 -
Ultimate Guide On The 6 Basic Types Of Index Funds - 10th Jan 21
Getting Vaccinated at TESCO - Covid-19 Vaccinations at UK Supermarket Pharmacies and Chemists - 10th Jan 21
Cheers for the 2021 Stock Market and These "Great Expectations" - 9th Jan 21
How to Plan Your Child With Better Education - 9th Jan 21
How To Find The Best Casino - 9th Jan 21
Gold Is Still a Bargain Buy - 8th Jan 20
Gold Price Set to Soar as Hyperinflation Looms - 8th Jan 21
Have Big Dreams? Here's How to Pay for Them - 8th Jan 21
Will the Fed Support Gold Prices in 2021? - 8th Jan 21
Stocks trading strategies for beginners - 8th Jan 21
Who is Buying and Selling Stocks in 2021 - 8th Jan 21
Clap for NHS Heroes 2021 as Incompetent Government Loses Control of Virus Again! - 8th Jan 21

Market Oracle FREE Newsletter

FIRST ACCESS to Nadeem Walayat’s Analysis and Trend Forecasts

Volatility As a Stock Market Indicator

Stock-Markets / Volatility Aug 27, 2007 - 03:13 PM GMT

By: Hans_Wagner

Stock-Markets

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)

Monthly Data: S&P 500 Index Average Daily Range
Quartile Volatility Range %Chance Up Month % Chance Dn Month If Up Avg Gain If Down Avg Loss Expected Gain/(Loss)
1 st
0% - 1.0%
70%
30%
2.7%
-1.8%
1.3%
2 nd
1.0%-1.4%
61%
39%
3.1%
-2.2%
1.0%
3 rd
1.4 -1.8%
59%
41%
3.1%
-3.1%
0.6%
4 th
1.8%-2.6%
44%
56%
5.0%
-4.6%
-0.4%
Annual Data (1962 – 2006): S&P 500 Index Average Daily Range
Quartile Volatility Range %Chance Up Month % Chance Dn Month If Up Avg Gain If Down Avg Loss Expected Gain/(Loss)
1 st
0% - 1.0%
91%
9%
14.3%
-1.5%
12.9%
2 nd
1.0%-1.4%
82%
18%
19.1%
-9.0%
14.0%
3 rd
1.4 -1.8%
82%
18%
15.6%
-11.6%
10.6%
4 th
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.

By Hans Wagner
tradingonlinemarkets.com

My Name is Hans Wagner and 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 at http://www.tradingonlinemarkets.com/

Hans Wagner Archive

© 2005-2019 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


Post Comment

Only logged in users are allowed to post comments. Register/ Log in

6 Critical Money Making Rules