The statistical volatility

Last Updated: Fri, Sep 21, 2012 03:48 hrs

What is volatility? Why is understanding volatility important? Is there a recurring pattern in volatility? Put simply, volatility is a variation of prices over time. There are different types of volatility. In this update we have looked at historical volatility aka statistical volatility (SV).

Everything animate is connected. Markets are alive owing to its participants and the sentiment they bring to the market place. This is why understanding market volatility gives us cues about market sentiment. If we can understand sentiment, we can understand biases, trends and inherent risks. Understanding sentiment will also suggest whether betting against sentimental investors is costly and risky or profitable.

We have mentioned this prior that volatility, sentiment like many other market variables, behave counter intuitively. According to a research on ‘Investor sentiment in the stock market’ by Malcom Baker and Jefrey Wurgler of NBER, “what has low sentiment in previous months delivers higher average returns and what has high sentiment in previous months delivers lesser average returns”. This again is an extension of the idea that worst performers end up outperforming the best performers. It also suggests that what is lacklustre, uninteresting from a sentiment point of view is what will deliver. This all makes sentiment investing counter intuitive.

And counter intuitive is the reason why patterns whether of volatility, sentiment, value, etc. recur. Hence, seasonality and cyclicality happens. In this latest update we look at SV, which also confirms the counter intuitive view on most occasions. We have considered quarterly and monthly holding periods. In most cases rising statistical volatility (aka increasing excitement or sentiment) is leading to a fall in prices rather than otherwise.

SV for Dow 30 on a quarterly basis has mostly happened near market lows. It’s near or around market lows that the volatility mostly hits a high. The lows of 1930s, 1940s, 1960s, 1970s, 1980s, 2000s and now all saw rising SV. Most rising volatility periods were accompanied by falling prices. Now SV for Dow 30 is reversing from a historical 30 per cent level, which looking at the conventional pattern suggests strengthening or upside on Dow rather than weakness or fall. This flies in the face of any anticipated September-November negative seasonality.

For the Indian Sensex, the monthly SV trend is negative; we need a rising SV to anticipate intermediate negativity ahead. Despite the negative looking head and shoulder formation on MSCI Asia ex-Japan, the SV for the respective index is still falling. This suggests that expecting a large distribution on MSCI Asia ex-Japan might be premature. We need to see some negative price confirmation first.

Sectorally speaking, Indian banking has a falling SV i.e. anticipated positive price action. BSE Auto has a falling SV, again anticipated positive price action. Even CNXIT has falling SV (anticipated positivity in price). Only BSE Healthcare has a bottoming SV. This suggests that the outperformance on BSEHC could be getting ahead of itself.

Globally, dollar index has a reversing SV suggesting that all falls should be considered buying dips rather than otherwise. WTM crude has falling SV suggesting positive crude oil prices. As natural gas SV fell, its prices rose. Now that natural gas SV is nearing a bottom, it suggests that maybe we are in for another new low on natural gas. Gold has a rising quarterly SV and falling monthly SV. Conventionally speaking this still suggests a sideways to neutral action on gold (dollar terms). The gold choppy action should continue for multi weeks.

It would be interesting to see what works in the coming September – November time window. We have sequences of resistances, negative seasonality, overbought multi week momentum on one side and quarterly falling SV and quarterly bottoming momentum on the other. How key is the statistical volatility variable in the weight of evidence equation remains to be seen.

The author is CMT, and Co-Founder, Orpheus CAPITALS, a global alternative research firm

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