Basic Volatility Characteristics
I’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 night’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.
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| Figure 1. June 99 D-mark, daily. Source: Omega Research.
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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.
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