Saturday, July 07, 2007

Anticipating Volatility in the Stock Market

Traders commonly focus on market direction, trying to anticipate bull or bear moves. Equally important, however, is anticipating market volatility. Without an understanding of how volatile the market is likely to be, it is difficult to set appropriate stop loss points and profit targets. But how can we know how much movement to expect in the market?

I decided to look at several possible predictors, going back to the start of 2004 (N = 883 trading days) in the S&P 500 Index (SPY).

Strongly associated with a day's volatility is the volume of trade for that day. Indeed, the correlation between SPY daily volume and the high-low trading range for the day session in SPY is an impressive .49. That means that about 25% of all variance in market movement can be explained by the participation of many traders--and large traders.

Another powerful predictor of daily volatility is the level of option volatility: the VIX. The correlation between the closing VIX level for the day and that day's volume is .43. Clearly, volatility among options premiums is associated with volatility in the daily trading range of stocks.

When we join those two factors, daily volume and VIX correlate in a multiple regression about .60 with the high-low range for SPY.

If we look at the prior day's closing VIX and the current day's high-low range in SPY, we find a correlation of .36. Interestingly, the current day's high-low range also correlates .23 with the size of the opening gap in SPY (i.e., the absolute magnitude of the move from the previous close to the current day's open). The correlation between the current day's high-low range and the prior day's high-low range in SPY is .20.

A multiple regression of the prior day's VIX, trading range, and the opening gap yields a multiple correlation of .38. That suggests that, of the preceding predictors, the prior day's closing VIX accounts for the lion's share of variance in the present day's volatility.

Accordingly, it makes sense to use the VIX as an estimate of the likely volatility for the current trading day, but to continuously update this estimate on the basis of the current day's trading volume. By identifying whether the current day's volume is above average, average, or below average and then seeing how these volume levels have interacted with VIX levels in the past, we can make reasonable estimates as to the likely movement for the coming day.

More on this strategy to come.

RELEVANT POSTS:

First Half Hour as a Volatility Indicator

Intraday Volume and Volatility

What You Can Learn From the Opening Minutes of Trading
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10 comments:

Ziad said...

I'm quite interested to know how one could apply this idea practically in real life trading. Did you look at the absolute level of VIX in ur study or at the relative level vs. its own MA? And how would you use these levels to predict range?

Also, the last sentence "seeing how these volume levels have interacted with VIX levels in the past" is pretty vague to me. How would you go about doing this?

I hope u'll be following this article up with more insights because it's such an important and highly overlooked area for most traders. I, myself, am still searching for a good way to *anticipate* volatility. The problem with the volume correlation is that it's after the fact. i.e. Once you notice that volume is coming in above average, many times the big move has already been made. The challenge, and area with the most potential for creative thinking, is to be *predictive* in volatility assessment so that you can choose appropriate stops and targets before the daily range has already played out. That's why the VIX's previous close is such an interesting idea.

DayTrading said...

You said:

"That means that about 25% of all variance in market movement can be explained by the participation of many traders--and large traders."

Volatility does not neccessarily beget higher volume. It could be that a higher volume and activity in the market causes the triggering of stops which is what causes the volatility. So it may be that volume is the cause and volatility the effect.

Brett Steenbarger, Ph.D. said...

Hi Ziad,

Thanks for the note. I used the absolute VIX in my study. My post on my Trader Performance page (www.brettsteenbarger.com/trader_performance.htm) elaborates how I view volatility as a function of VIX and volume.

Brett

Brett Steenbarger, Ph.D. said...

Hi Daytrading,

Thanks for the comment and sorry for any confusion. I believe that the causal relationship involves large traders entering a market with a directional bias, generating enhanced volatility and increased likelihood of breakout trades.

Brett

Josh Ulrich said...

Volatility does not neccessarily beget higher volume. ... So it may be that volume is the cause and volatility the effect.

It's more likely that volatility and volume are not functions of each other, but are simultaneously determined by market agents.

AnaTrader said...

Hi All

I believe we should pause and observe a minute of silence to pay respect and show our sympathy for Dr Brett and his family on the demise of his beloved mother.

Brett, please take a break and be with your father to comfort him and the whole family.

We can wait.
With heartfelt condolences

Ana
Singapore

Brett Steenbarger, Ph.D. said...

Thanks AnaTrader,

Yesterday's loss of my mother was indeed a difficult one for me. She taught me much, including the importance of caring about others. Thanks for your kind note.

Brett

Michael said...

Sorry to hear about your mother, Brett. My thoughts are with you and your family.

Hubert Senters uses a rule of thumb for volatility that I find very practical. He calculates the high-low range of the Dow 30 for the first 30 minutes of trading. If it is less than 35 points, it's likely to be a range-bound "chop" day, and he alters his intraday trading strategies accordingly. If I know half an hour into the trading day how the market is likely to trade for the rest of the day, that's mighty empowering.

Regards,
Michael
Lakewood, CO

DayTrading said...

Very sorry to hear about your loss Brett. My condolences are with you and your family.

Simply Options Trader said...

Dr Brett,
Sorry to hear about the demise of your mother. My heartfelt condolences and please take care.