Thursday, October 29, 2009

A Jump in Stock Market Volatility and Its Implications

Here we see the S&P 500 Index (SPY; blue line) plotted against the average five-day high-low range for SPY. Notice the significant jump in volatility during the recent selloff, as the average range has essentially doubled from its October lows. This has meant in recent days that the more distant profit targets, as published each morning before the market open via Twitter (follow here), have been consistently hit and even exceeded.

It is interesting that many traders will adapt to directional changes quicker than they adapt to shifts in volatility. That is, they will notice a breakout or trending move, but will not adjust stop loss levels and price targets to account for enhanced (or dwindling) volatility. The increase of volatility becomes a double-edged sword when traders trade well vs. poorly: if a trader increases his or her size in a rising volatility market, the variability of daily P/L will rise significantly. That is why going on tilt in a rising volatility environment can be so dangerous.