Iâ€™ve received a number of e-mails asking for an introductory column on historical volatility (HV). Briefly explained, shorter-term market volatility levels tend to revert to longer-term volatility levels. This basically means that after markets go through a few days of craziness, they become more quiet. Conversely, when markets go through periods of extreme low volatility, they generally move very violently.
In 1995, I created a specific formula using historical volatility (HV) to help me better determine when market explosions are more likely to occur. For example, one of the indicators we use is the 10-day HV vs. the 100-day HV (10/100 HV). What this does is measure the 10-day (shorter-term) vs. a more normalized 100-day (longer term) reading. When the 10-day reading drops to one-half or less of the 100-day reading, it identifies points when markets are likely to make larger-than-normal moves. These moves occur as volatility “reverts to its mean.”
Some of you have emailed us, asking how Dave Landry knew (in Tuesday nightâ€™s Futures Market Trading Outlook) that the D-mark was likely to experience a larger-than-normal move. Looking at Figure 1, on 5/25/99 the 100-day HV reading was 8.8% but the 10-day reading was less than half, at 3.7% (A). A big move was necessary for the 10-day level to revert to back to the 100-day level. In this case, the June D-mark (DMM9) had its largest one-day move in over a month (B) as volatility reverted to its mean.
|Figure 1. June 99 D-mark, daily. Source: Omega Research.
I have found a number of ways of taking advantage of this inherent market feature. Please read some of my earlier columns–they build upon this theme even further.