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Super Low Volatility and Next Day Performance

January 6, 2010

Related Reading: Bill Luby mentioned this first here http://vixandmore.blogspot.com/2010/01/spx-historical-volatility-at-two-year.html

In looking at my DVPV or “percentrank” volatility indicator these days I noticed that the numbers have dropped so low I can barely see the line on my Tradestation screen. This indicator simply measures 30-day historical volatility and normalizes this figure using percentiles (hence the percentrank). Right now, we are in a “super” low volatility regime–which can be defined by historical volatility being less than the 5th percentile which has a tendency to be temporary and revert in the longer term. When measured differently using the term structure of volatility (VIX vs VXV) this has intermediate-term bearish implications as highlighted in Rob Hanna’s Quantifiable Edges Subscriber Letter http://quantifiableedges.blogspot.com/ that I read every night. While I do not claim to be an expert in the topic of volatility, I do notice a lot of mis-informed new pundits/and financial media stars suggesting that this ultra-low volatility is highly negative in the short term. Contrary to popular belief, this is actually not true at all. Lets look at some quick stats:

“Super”-Low Volatility Regime: Last 3000 bars on SPY (S&P500)

close<200 day sma 0.04% 55.6%
close>200 day sma 0.08% 56.9%
today is a down day 0.09% 55.6%
today is an up day 0.08% 58.9%

The implication is that super-low volatility is uniformly bullish. Not much difference regardless of whether the  short or long term trend was up. In fact, if today was an up day this tended to have the highest edge overall with nearly 60% of winners the following day and the edge has actually been even higher in recent times. A couple notes–over a third of this edge in the super low volatility environment was realized in the overnight market which is typical of bull markets in general. Given that the next day return was fairly low on average—on balance this setup presents little opportunity for day traders short of catching the odd major breakout/breakdown. I will qualify however that the current setup is mildly negative for the next 5 days given that the DVI>.5 and several other indicators present a slight bearish bias.

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One Comment leave one →
  1. toptick permalink
    January 6, 2010 10:29 am

    Seeing the tight trading range in mid-December, I did a DV-influenced analysis of the SPX from 1950. Defining a volatility squeeze as days in the lowest 5% of 20-day ranges, I found that
    a) breakouts were somewhat more likely to be to the upside (as has happened since the analysis), and
    b) the average 40-day return of an upside breakout was noticeably larger in magnitude than the average return on downside breaks.

    I don’t want to be caught saying something nice about CAPM, but it is consistent that as volatility increases, the equity risk premium also increases, which resolves in the form of lower prices. For me, this is the rationale for the market having V bottoms — volatility is highest with low prices.

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