Imagine a market in which price was totally constant throughout the day. The open, high, low, and close price for the day were the same. In such a market, we would have perfect consensus regarding value. The market would be expressing a high degree of conviction regarding the placement of value.
Now imagine a market in which price fluctuates wildly throughout the day, perhaps as the result of a stream of news events and economic reports. A different and unique price is present at every time period within the day. Such a market would display little consensus regarding value. The market would be expressing a low degree of conviction regarding the location of value.
Volatility is intimately linked to uncertainty. A low volatility market is one in which traders are in relative agreement about their valuations. In a high volatility market, valuations are all over the place. Think of the market as a single person trying to come up with a number that represents ideal value. The non-volatile market is one in which the person is more certain of his or her value estimates.
The question then becomes: Are returns superior in a market environment characterized by high consensus/low uncertainty or low consensus/high uncertainty?
As it happens, the past three days in SPY have been a period of unusually high consensus. The three-day range of prices has been among the lowest that we've had since 2004 (N = 687 trading days).
In all, we've had 61 trading occasions since 2004 in which the three-day range in SPY has been below 1%. Three days later, SPY has been down on average by -.36% (19 up, 42 down). That is quite a subnormal return. The average three-day price change for the sample as a whole has been .08% (380 up, 307 down).
Conversely, when the three-day range in SPY has been greater than 2% (N = 177), the next three days in SPY have averaged a gain of .16% (107 up, 70 down), with five-day returns continuing to outperform.
One implication is that markets reward risk assumption. The safest times to trade--when there is relative consensus regarding value--offer subnormal returns, whereas the least certain--and seemingly most risky--periods to trade offer outperformance. A trading strategy that avoids volatility is not just a risk management strategy, but also an opportunity limiting one.
Note - I will be offering a free Webinar today at 3:30 PM CT. The topic is "Assessing Market Psychology"; the session is sponsored by the Chicago Mercantile Exchange and hosted by Advantage Futures. Interested traders can register here.
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