Thursday, September 10, 2009

Historical Volatility Demystified Part III

In theory historical volatility is blind to the trend of the stock, thus it shouldn't be used to predict stock direction. For example, suppose HV is high and you think it will begin to come back down to its average. Does that have any influence on your outlook on the stock? In other words, if you think HV is going to drop, does that mean the stock price will drop also? If you subscribe to the notion that volatility is blind to trend, then the answer is no. Remember HV measures price movement, not price direction. HV can be moving down whether the stock price is rising or falling. Conversely, HV can be moving up whether the stock price is rising or falling. Although theory states that there is not necessarily a direct correlation between HV and price direction, in the real world there usually is a distinct relationship between HV and price direction.

You have all probably heard that stock prices tend to fall faster than they rise. To give credence to this claim let’s review the last 10 years of the S&P 500 Index which encompasses two bull markets and two bear markets. When the S&P originally rose from 800 to 1500 it took approximately 3 years and 1 month (February 1997 to March 2000). During the ensuing bear market it took a mere 2 years and 4 months to fall from 1500 back down to 800 (March 2000 to July 2002). A comparison of these two time frames shows the market fell about 32% faster than it rose. From the July 2002 lows of 800, it took the S&P about 5 years and 3 months (July 2002 to October 2007) to rise once again back to 1500. As you are all aware, the market has taken quite a tumble since the October 2007 highs. Incredibly the S&P dropped from 1500 back down to 800 in a mere 1 year and 1 month (October 2007 to November 2008). A comparison of these two time frames show the market fell about 384% faster than it rose. There are certainly exceptions to the rule (gold and the VIX come to mind), but it is indisputable that over the last decade stocks have fallen quicker than they’ve risen.

[Source: EduTrader]

If you accept this notion then you also must concede that stocks tend to exhibit more volatility when they fall than when they rise. In other words, there tends to be an inverse relationship between HV and price. For example, look at the following picture and focus on the relationship between HV and the stock price. Take note of the grey arrows which illustrate HV’s tendency to increase as the S&P 500 falls in price and decrease as the S&P 500 rises in price.

[Source: EduTrader]

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