Sunday, April 09, 2006

Volatility Spike: What Comes Next?

Friday's weak market raised the VIX, the measure of implied option volatility on the S&P 500 Index, by 8.79%. I went back all the way to January, 1990 (N = 4099 trading days) to see what happens after such a one-day volatility spike. Looking at the Dow Jones Industrial Average, I found an interesting pattern. For the group of volatility spike days (N = 329), the first hour of trading on the next day tended to be down and that next day tended to underperform the sample average. By three days out, however, there was no underperformance. Interestingly, however, since 2003 (N = 48) the first hour of trade after the volatility spike day has been up in price (29 up, 19 down), but the day overall has underperformed (-.04% vs. .04% for the sample overall). Three days out, this underperformance has largely disappeared--although I'm not seeing the three-day outperformance with the Dow that I noticed earlier in the S&P. It may well be that, after a very broad decline, it is the very broad market (not the large caps) that snaps back the most.

Finally, a reader asked about Fridays in particular. As the reader suspected, when the volatility spike day occurs on Friday, Monday has tended to be much weaker in the first hour, but largely recovers by the end of the day. This pattern has not been especially strong since 2003.

In general, broad weakness is associated with underperformance in the very short run, but reversal thereafter. This trade concept will frame my expectations for the start of the week, as I'll outline in tonight's Weblog.

ADDENDUM: I notice that, when you break the sample of volatility spike days down by the resulting VIX level, the three day outcomes for low VIX occasions (such as at present) are actually bearish. When the VIX after the spike is less than 15, the next three days in the Dow average a loss of -.17% (26 up, 31 down)--much less than the average gain of .12% (2260 up, 1849 down) for the sample overall. The results are even more bearish when we just look at the findings since 2003 (N = 22). Three days later, the Dow is down by an average .40% (8 up, 14 down). For me, such findings are a heads-up, warning of the dangers of being too complacent in bottom fishing. Such heads-up findings proved hugely profitable last October, when weakness led to further weakness for quite a few days.

6 comments:

yinTrader said...

Hi Brett

I will take up your advice to focus on trading one or two instruments, initially, while learning. As mentioned before, I am learning to trade in eMini S&P500 and in FX.

I refer to your comments on Friday closing re VIX: seems to me that when it closes weak on a Friday, by Monday it opens weak but reverses by day end. Going by your 3 days period on reversal , I count Friday, Saturday and Sunday as 3 days period, to see reversal on Monday.

Is this thinking valid?

Brett Steenbarger, Ph.D. said...

Hi,

Sorry for the confusion. Three days refers to trading days and does not include weekend days. Please also note the addendum to the post, which raises doubts about meaningful reversal. It is going to be very important to monitor intraday strength and weakness as the market is trading before committing to a particular market scenario. The historical analyses I'm posting are intended as guidelines to what has happened in the past, not as mechanical trade ideas.

I recommend several online trading rooms as ways of learning how to monitor markets in real time. Woodie's CCI Club, Linda Raschke's trading room, and John Carter's Trade the Markets service come to mind as excellent alternatives.

Brett

yinTrader said...

Thank you, Brett, for the clarification; seems to be coincidental when I factor weekends into the count.

I have been reading Linda Raschke too. There is so much to read and so much to digest, but stimulating to explore , yours in particualr, as Psychology makes up 60% of success formula, 10% for Planning, 30% for Money Management, n'est pas?

Merci.

Brett Steenbarger, Ph.D. said...

Thanks for your observations. I think that 100% of trading expertise boils down to talent (native abilities), skills (acquired competencies), and a focus on markets and trading styles that offer opportunity. Once a trader develops such expertise, psychology becomes crucial to performance. For beginners, psychology is much less important than skill development and locating opportunity, IMHO.

Brett

yinTrader said...

D'accaord, Brett.

My mentor Ray Barros would be happy to note that I need to focus now on skill development and locating opportunities - to enter and exit a trade.

Merci.

Brett Steenbarger, Ph.D. said...

Yes, having a proper psychology will help you execute those skills, but cannot substitute for the work of developing those skills. That is why I always recommend developing skills in simulated trading prior to entering markets live.

Brett