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Is an Increase in Realized Volatility a Bearish Warning? (Preview)

By Lawrence G. McMillan

In our market commentary for the past few weeks, we have occasionally mentioned the fact that realized volatility (the 20-day historical volatility, say) of $SPX was very low and that a sharp increase in that volatility measure would not be good for stocks. This is somewhat akin to how we view implied volatility ($VIX) in that we are not too concerned when it is low, but do become cautious when it starts to rise. The difference in the two is that realized volatility is backward-looking, while implied volatility is forward-looking. On the surface, one might think that forward-lookingwould be better, except that we don’t know who’s doing the looking. Sometimes, $VIX seems to get distorted, so perhaps there are times when realized volatility could be a better measure.

In any case, we ran a study with very simple parameters:
1) if the 20-day historical volatility of $SPX falls below 8.0%, then we will be on alert for a sell signal.
2) the sell signal occurs when the 20-day HV rises above 10.0%.

We didn’t define any parameters beyond that...

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