Friday, October 17, 2008

Current Market Volatility

Among the readers of my blog, I found that yesterday someone had come from this blog post, written in February of this year. Nevermind the novice level of the author's investing. What caught my eye was his view of my partner's and my development of a market volatility measure for use with options. He wrote, in part,

"I find C Neul’s description of how they found a new indicator of the market direction kind of suspect, in the way that one retrofits and backtests ideas against a particular sample to use as a new indicator of future direction. Then again, I’m not a fan of any kind of technical analysis, which this clearly is. But the surety of how he describes this measure (”standard deviation of daily total returns of the index”) as a way to make predictions about future moves is what I find least appealing — for a “skeptic”, he sure seems pleased with the new measure, that happens to fit his specific sample. Still kind of amazed that professionals do this, but I suppose if everyone took my stance the shell game would fall apart."

I learned quite a few years ago that any successful equity portfolio management process has to have some link to the market. If portfolio management is done in isolation, it inevitably leads to buying and holding equities when there is simply no way to earn positive total returns. Sometimes for periods as long as two or more years.

To avoid emotionally-based decisions, some sort of 'technical' indicator is a good idea.

In our case, we determined that our equity risk management tools were insufficiently sensitive for use with equity options.

Thus, we chose to develop new tools.

The nearby chart displays the recent levels of the trailing standard deviation of daily S&P returns, which we have found to be extremely powerful in predicting certain market conditions of interest to us, as we manage equity derivatives portfolios.

The measure aptly captures the meteoric rise in S&P volatility just since Labor Day. Note, if you will, that we developed the measure in February. Since then, it has continued to capture volatility and work in conjunction with our other risk measure.

So, contrary to the other blogger's contentions, it has worked ex poste, as well as ex ante.

Seeking historical context, I applied our measure to the S&P500 from 1950 to the present in additional research conducted just last month. That nearby chart shows that the crash of 1987 was even more volatile than our current market situation- so far.

Extending the analysis back to 1928, via the Dow Jones Industrial Average, I found that the market volatility for that crash exceeded even that of 1987.

All of which is to state that the current equity market volatility is the third-highest in 80 years.

For our equity derivatives portfolios, that means a change in allocation. Having the historical perspective of this measure since 1928, we were able to calibrate absolute levels of the measure which correspond to allocation decisions for our derivatives strategy.

Further, we have historically-based expectations of how long the current period of extreme volatility is likely to last.

Buckle up for an extended ride.

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