One way to look at short-term price range probabilities is to project the potential prices from the current level in an expanding cone based on the level of historical volatility and the level of options implied volatility.
In the absence of special new forces (such as fear of the collapse of the eurozone), historical volatility may be a more reliable projection basis. However, in times of intense sentiments or strong external events, the volatility that is implied by options pricing may be more reliable. The VIX provides the options implied number for a 1-month forward view.
Both the historical and options derived methods are worth taking into consideration along with other factors.
Let's see what those price probability ranges look like for the S&P 500 now after a few weeks of negative market action and intensifying headlines about Europe.
If you use mental or automatic stops, price probability cones can be useful tools in selecting trigger prices (and if you buy or sell options they are helpful too -- we like to use probability cones when the VIX is high to write cash secured PUTs on stocks we'd like to own at much lower prices).
Figure 1: Historical Volatility Implied Probable Price Range
This graphic uses the S&P 500 proxy SPY (price at about 1/100th of the S&P 500 index level). Since SPY is the investable vehicle outside of the futures market, we prefer that for study.
The orange cone is based on 3-months of historical volatility and projects a probable price range out 1-month at 96% probability.
That means there may be only a 2% chance of price lower than the lower bound of the cone by 06/17/2012.
This tool makes the gross assumption that the prices follow a normal frequency distribution, which is not actually true, but nonetheless the math is the basis of much investment analysis, and is a broadly reasonable approximator for probable behavior.
The 96% probability range corresponds to 2 standard deviations, beyond which the highly unusual is expected to be required to take place for the prices to go outside of the cones.
The chart adds a few other helpful plots. The blue lines mark the 3-month price channel. The gold line is the 200-day moving average. The red lines plot offsets from the trailing 1-year high. The dashed red line marks a 10% offset ("correction"). The solid red line marks a 15% offset ("extreme correction"). The bold solid red line marks a 20% offset ("bear market").
The horizontal black line marks the closing price today, whereas the other data is as of the market close yesterday.
We'll tabulate the values indicated by Figure 1 and Figure 2, after presenting Figures 2 and 3.
Figure 2: Options Volatility Implied Probable Price Range
The orange cone is Figure 2 is based on the VIX (the options implied forward volatility). You can see by the wider mouth of the cone that the options market is expecting a lot more volatility than has been seen in S&P 500 over the past 3 months.
The other indicators are the same as in Figure 1.
Figure 3: VIX versus S&P 500 Weekly For 7 Years
The S&P 500 is shown in black and the VIX is shown in red. You can see that there are occasional spikes in volatility (fear), with a corresponding drop in index prices, generally followed by a calm and generally rising index prices.
There was a big spike in 2010 about the time of the Flash Crash, and there was a spike in 2011 Q4, the last time Greece and Europe were the major worry.
If you don't believe the world will end, high fear times can be a good time to sell short-term (1-3 month) cash secured PUTs on stocks you'd like to own by setting exercise prices outside of price probability cones. If you are certain you'd like to own a stock at that lower price, and confident that you would buy some at that lower price, then why not get paid to promise to do so. Probabilistically, you will not be called upon to perform, but if you are, you buy what you were convinced you would buy at that price any way. Be sure you fully understand what you are doing before trying that.
The VIX is elevating again, but is not at the high levels of prior spikes, which suggests, in combination with Greece in the headlines again, that more downside is likely.
Price Level indications From the Charts:
Looking at Figure 3, we see 110 as a feasible price for SPY (S&P 500 divided by 100). Since that is where it went in the last Greek tragedy, it seems plausible that it could do so again. On the other hand, if its Greece alone, that may start to be a bit of a yawn. The issue now is greater contagion concern.
Clearly, the probability charts go equally up and down, however, this article is focusing on the downside risks. We think it is obvious from the charts and from the news that the negative risks should be more of a short-term concern than the upside. We are not aware of any analysts predicting a short-term rise to 154 based on the VIX, but it is not hard to find those looking for the 115 based on the VIX.
This table summarizes the price levels plotted by the various indicators in the charts:
We are not offering a prediction here, just the tools that help bracket probabilities, and hope you find it helpful.
Disclosure: QVM has positions in SPY as of the creation date of this article (May 17, 2012).
Disclaimer: This article provides opinions and information, but does not contain recommendations or personal investment advice to any specific person for any particular purpose. Do your own research or obtain suitable personal advice. You are responsible for your own investment decisions. This article is presented subject to our full disclaimer found on the QVM site available here.