5 Key Points on Volatility Clustering

I have written about the topic of volatility clustering a number of times, and thought I would update the post here. Many people trot out the highly misleading statistic about missing the best 10 days as a reason excuse for buy and hold investing. It drives me crazy to the point I have considered writing a paper on the topic. Great background reading here from Gire and Estrada. Stay tuned.

However, this line of reasoning is way too simplistic. The basic math shows that the vast majority of up AND down days occur when the market has already been declining. The simple reason? The market is more volatile. The last eight months have been a perfect example. I updated the post I wrote a while back entitled "Dow 300 Point Days and Volatility Clustering". An older post here - "More on Volatility Clustering".

Below I take Yahoo DJIA data back to 1929 and the key takeaways are:

1. The market goes up two-thirds of the time.

2. All of the stock market return occurs when the market is already uptrending.

3. The volatility is 80% higher when the market is declining.

4. Roughly 75% of all of the best AND worst days occur when the market is already declining. Reason: see #3.

5. The reason markets are more volatile when declining is because investors use a different part of their brain when losing money. Reminds me of the behavioral reasons listed by Lo in this earlier video.

Below is a chart from my book with monthly data on a few other asset classes.

Comments

[Mad Hedge F...:]

I like the concept. There is a great debate raging in the markets right now over the stubborn persistence of the volatility index (VIX) remaining over 40%. Is it still too risky to go back into the market? Are we going to new lows? Is the next big move an updraft or a downdraft? Part of the confusion springs from a misunderstanding of what the VIX is. It is just a mathematical guess about how big the next move in the market will be. A 40% VIX implies that one out of three days will see a 2.25% palpitation, and once a month we will suffer a 4.5% gyration. You can have the market drop 10%, rise 11.1%, remaining unchanged, but still generate a tremendously high VIX. The equation doesn’t care what the direction is. VIX unfairly picked up a bearish connotation because of the panicked rush by long side only investors to buy downside protection in falling markets, driving put implied volatilities through the roof. This is why investors associate a high VIX with falling markets. In the end, this debate can only be resolved in one way, and that is to the downside. Smart hedge funds are now shorting out of the money calls on VIX. VIX will crash when markets go to sleep, as they inevitably will. Be careful what you wish for. Traders don’t pull down million dollar salaries playing “Solitaire” on their computers.

Apr 05 01:27 PM