Tuesday, August 05, 2014

When Volatility Becomes More Volatile: What Does That Mean?

What does it mean, psychologically, when the volatility of a market, stock, or asset is high or low?  The purpose of markets is to establish value for buyers and sellers.  In a world of perfect unanimity, where buyers and sellers totally agree on value, there will be little or no volatility.  In a less certain world, there will be differences in the placement of value.  When those differences become extreme, we have volatility.  It is in that context that measures of the implied volatility of a stock index (the volatility implied by options pricing), such as VIX, can be considered a measure of uncertainty.  Each individual participant may feel certain regarding their assessment of value, but the assessments of participants overall are widely distributed and hence convey uncertainty.

When the volatility of volatility is elevated, then we see not only extreme differences in the placement of value, but frequent shifts among these placements.  Vol of vol is thus a good measure of the relative stability or instability of a market's basic function:  setting value.  It is not surprising that vol of vol becomes extreme during periods of great market instability, such as 2008.

If you click on the chart above, you will see SPY plotted against the five-day realized volatility of VIX from 2012 to the present.  As you can see, we have moved very quickly from a low vol of vol environment to a high one.  A look at prior, similar elevations in vol of vol finds that these have occurred during corrective periods in SPY and, on average, have been good points to hunt for stock market bargains.  Indeed, going back to 2012, we find that the top quartile of occasions of highest vol of vol have led to an average next five-day return of .63% vs. .27% for the remainder of the sample.  The market has rewarded those who have used periods of instability to buy bargains in stocks.

The challenge, of course, is that instability can become greater instability before prices move higher and markets become more orderly.  What is important is for traders and investors to decide whether the current instability is more of a transient fearfulness in markets (as has been the case since 2012) or whether it reflects more fundamental instability (as was the case in 2008).  At the very least, the rise in market volatility and the volatile moves in volatility should prod traders and investors to review the sizing of their positions and the correlations within their portfolios.  It's when those correlations move toward 1 and volatility and vol of vol spike that seemingly prudent risk-taking can suddenly pose a risk of ruin.

Further Reading:  Volatility of Markets and Moods