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We are currently, in March 2020, in one of the three most volatile markets in history. In terms of absolute price change, it has no peers. In terms of percentage price change, 1929, 1931-1933, and 1987 are all in the mix (but not 2008, which has been surpassed). If we looked back even farther, there would be other markets which were volatile, too (1907, for example), but in this paper we are not looking back past 1928.
Since we are at the inception of a new year and a new decade (if you adhere to the notion that the decade begins with 2020 and not 2021), it is sometimes useful to see how the patterns of previous years have played out. The top chart on the right is a composite of all years ending in ‘9.” The orange line shows how the “average” of all stock market years has performed. The Blue line depicts the performance only of years ending in ‘9,’ and you can see that it is strong. Typically there is a decline early in the year (January-February) and then it’s off to the races for the remainder of the year – with minor corrections in May-June and September-October. The year that just concluded (2019) didn’t fit that pattern exactly, but it was certainly a very bullish year (Compare the chart in Figure 1 on Page 1).
John Bollinger has done a lot of work discussing the ramifications of the width of Bollinger Bands. In short, if the Bands are too close together (too compressed), then volatility is “too low,” and the market is due for an explosive move – probably to the downside. Conversely, if the Bands are quite far apart, then volatility has gotten “too large” and a contraction in volatility – and probably a stock market rally – is at hand.
The CBOE introduced the Volatility Index ($VIX) in 1993. The calculation of $VIX has changed a couple of times over the years, and due to the complexity of those calculations, $VIX itself cannot be traded. However, in 2004, $VIX futures were listed, and in 2006, $VIX options were listed. $VIX futures are the underlying instrument for all of the Volatility ETN’s and ETF’s that exist today (VXX, for example).
There is a seasonality to volatility that has persisted over the years. Not every year is the same, of course, but the general pattern is similar. This can sometimes be useful in helping one determine whether to expect increasing or decreasing volatility during the life of positions that are being established.
Many volatility traders – we are among them – complained about the lack of response by volatility derivatives during last fall’s market decline. That was especially true in the downward thrust in December. $VIX itself managed to put together a decent move, as it rose from 16 in early December to 36 on Christmas Eve. But one cannot trade $VIX; only the $VIX derivatives are available for trading.
Last Friday (January 18th) the “stocks only” breadth oscillator stood at +854.04 – the fourth highest reading of all-time. This is extremely overbought, but is not a sell signal (“overbought does not mean sell”). In fact, in the past, extremely overbought readings have often led to much stronger markets in the short term.
Last year (2018) was a very interesting year in a number of respects. One of those was the behavior of volatility and especially the behavior of volatility derivatives. Since one cannot trade $VIX but must instead trade one of the listed products – $VIX futures, Volatility ETN’s or ETF’s, or options on those instruments – there are some nuances involved. Since all of those instruments are based on $VIX futures1 , that is where we’ll concentrate this discussion.