What can be expected from low volatility markets?

• October 23, 2006
• Brett Steenbarger

My

recent research has shown that there is a close
relationship between the pricing of option premiums and future stock market
volatility.  Specifically, when the VIX has been low, we’ve seen
lower volatility among stocks going forward.  This is important for two
reasons:  1) volatility defines the amount of movement among stocks and hence
the opportunity available to active traders; and 2) we are currently in a period
of historically low volatility.

In this investigation, I will look at the big
picture, going back all the way to 1964 (N = 10,715 trading days) in the S&P 500
Index ($SPX).  My measure of volatility is simply the average high-low range for
a given period of time.  What makes the current time period interesting is that
we are seeing an average daily trading range in the S&P 500 Index of under 1%
for the past 40, 200, and 500 trading sessions.  This combination of low
intermediate-term and longer-term volatility has only occurred during 1415 of
the days in my sample, clustering during late 1984-early 1986, late 1992-1996,
and May, 2005 to the present.

I will be studying this sample of low volatility
occasions closely and reporting my results in the near future.  Several
immediate conclusions, however, are worthy of immediate note:

1)  All of the low volatility occasions
have occurred in the latter half of the data sample – I don’t think this
is coincidence.  As the S&P 500 Index has become a more widely traded instrument
and as it has become increasingly involved in arbitrage trade, we have seen
volatility leave that market.  If this is the case, we can expect further
volatility erosion with increased algorithmic/program/arbitrage trading.

2)  Low volatility can persist for a
considerable period of time – The notion that low volatility will soon
revert to its mean is simply not true.  Low volatility seems to beget low
volatility for many months on end.  Indeed, 60 days after a low volatility
period, the average high-low range in the S&P 500 Index is only .83%, much lower
than the average high-low range of 1.45% for the sample overall.

3)  We have never had a bear market within
60 trading days of a low volatility period – Yes, we’ve had market
corrections of about 5-6% in March/April, 2006; August, 2005;  September, 1994;
January, 1994; and July, 1985.  We have never had a decline of 10% or more,
however.  The idea that we are in a complacent market period and hence due for a
frightening drop is not supported by market history.

4)  As a whole, low volatility periods have
been good opportunities for buyers – Sixty days after a low volatility
period, the market has been up on average by 3.37% (1091 up, 324 down).  That is
considerably stronger than the average sixty-day gain of 1.86% for the entire
1964-2006 period (6779 up, 3934 down).  Those periods of 5-6% correction during
low volatility markets have been particularly good buying opportunities–as they
have been thus far during the current low volatility environment.

What can we expect from low volatility markets? 
At least in the past 40 years, we can expect more of the same, and we can expect
periodic market corrections that represent potential buying opportunities.  Yes,
there’s a first time for everything and this time might be different.  I’m not
holding my breath, however.

 Bio:

Brett N. Steenbarger,
Ph.D. is Associate Clinical Professor of Psychiatry and Behavioral Sciences at
SUNY Upstate Medical University in Syracuse, NY and author of

The Psychology of Trading (Wiley, 2003). As
Director of Trader Development for Kingstree Trading, LLC in Chicago, he has
mentored numerous professional traders and coordinated a training program for
traders. An active trader of the stock indexes, Brett utilizes
statistically-based pattern recognition for intraday trading. Brett does not
offer commercial services to traders, but maintains an archive of articles and a
trading blog at
www.brettsteenbarger.com and a blog of market
analytics at
www.traderfeed.blogspot.com.  His book,

Enhancing Trader Performance, is due for
publication at the end of October (Wiley).