Tuesday, September 09, 2014

Pure Volatility: A Measure of Stock Market Efficiency

The recent post took a look at a research-based measure I constructed for assessing buying and selling pressure in the stock market.  A different--and equally challenging--project has been the creation of a new measure of stock market volatility.  Across most time periods I've investigated, the volatility of SPY has been very highly correlated with the volume of trading--generally by .80 or higher.  For all practical purposes, the two are the same measure.

What I wanted to do is construct a volatility measure that is independent of volume.  This measure of what I call Pure Volatility represents the movement in the market per volume unit.  A high Pure Volatility market moves more for a given amount of volume than a low Pure Vol market.  If you click on the above chart, you'll see that zero represents average Pure Vol; values above and below represent high and low Pure Volatility.

Thus far in 2014, near term returns in SPY have been superior following high daily readings in Pure Volatility.  When daily Pure Vol has been in its highest quartile, the next day in SPY has averaged a gain of .14%.  Across all other quartiles, the next day in SPY has averaged a gain of only .01%.  Over longer time frames, the effect is even greater.  

What this suggests is that high Pure Volatility has tended to be associated with price momentum to the upside (high volatility strength leading to further strength) and reversal to the downside (high volatility weakness leading to rebound strength).  Backtests have been particularly promising when the Pure Volatility measure is combined with the measures of buying and selling pressure described in the previous post.  In particular, high buying pressure accompanied by high volatility has been associated with superior upside follow-through in SPY.  Odds for near-term reversals are higher when price strength is accompanied by low Pure Vol.

Markets with high Pure Volatility are relatively efficient, in that they move a great deal per unit of volume input.  Low Pure Volatility markets are inefficient:  they move little for a given amount of volume.  The tracking of waxing and waning market efficiency and inefficiency ends up being helpful in identifying intermediate-term turning points in the market--a topic I will address in a future post.

Further Reading:  The Volatility of Volatility and What It Means