How to Short Stocks in a Low-Volatility Environment

How to Short Stocks in a Low-Volatility Environment

Recently we’ve been working on a strategy for shorting stocks using ConnorsRSI as one of the primary indicators. You can find complete details in one of our quantified Strategy Guidebook: Short Selling Stocks with ConnorsRSI, but the basic idea is to use a limit order to short stocks that have achieved both an oversold ConnorsRSI value and a new N-Day high. When the price reverts to the mean, we cover our positions and take our profits, typically in less than two weeks time.

Short-term mean reversion strategies like this one tend to work best when there’s at least moderate market volatility. If stocks are not experiencing normal up and down price movements, then it can be difficult to find tradable edges. Furthermore, periods of lower volatility often coincide with market rallies, which are notoriously tough on short sellers.

Are you shorting stocks yet? Click here to learn more about our latest quantified strategy guidebook – Short Selling Stocks with ConnorsRSI.

Before we go on, let’s define what we mean by volatility. When traders use this term, they are typically referring to one of two types of volatility.

The first type of volatility is Historical Volatility, or HV, which may also be referred to as Realized Volatility. Historical volatility is something that we can observe and measure based on the past price movements of a security. It is typically calculated as the standard deviation of the security’s daily returns over some lookback period. For example, the 30-day historical volatility, or HV(30), calculates the standard deviation of the daily gain or loss from each of the past 30 trading days.

Volatility is almost always expressed in annual terms, regardless of the lookback period. Therefore, if a stock has an HV(30) value of 45, it means that if the stock continued to move as it has for the past 30 days, it would likely experience a total price change of 45% (up or down) over the next year.

The second type of volatility is Implied Volatility, or IV. Implied volatility cannot be calculated from historical prices of the stock, but rather is the byproduct of an options pricing model. In simplest terms, IV is an expression of the market’s expectation of the future volatility of the stock price between now and the option’s expiration. Market participants “express” themselves via the prices they are willing to pay for option contracts. Like HV, implied volatility is always annualized to make comparison of values more straightforward.

With those definitions in mind, let’s now look at the volatility of the overall market over the past several years. The first chart below shows the 21-day HV of SPY, and the second one shows the CBOE Volatility Index (VIX), which calculates the one month implied volatility of the S&P 500.

21-day Historical Volatility of SPY Through April 2013

Figure 1: 21-day Historical Volatility of SPY Through April 2013

VIX Through April 2013 Chart

Figure 2: VIX Through April 2013

You can see that both the backward-looking historical volatility and the forward-looking implied volatility (as reflected by VIX) tell a similar story about US market volatility. Both charts show a huge volatility spike in late 2008, and smaller spikes in mid-2010 and the second half of 2011. In addition, both charts show that the first four months of 2013 have been a period of relatively low volatility.