Monday, October 02, 2006

A Psychological Take on Volatility

The role of markets is to facilitate trade and establish value. Price is the measure of the degree to which market participants value underlying financial instruments and commodities.

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.