What Can We Expect From Low Volatility Markets?

Note: A version of this article appeared on the Trading Markets site 10/23/06.

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.

Brett N. Steenbarger, Ph.D.

www.brettsteenbarger.com

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