The Volatility Ratio: Does it signal market bottoms and tops?

by | Mar 8, 2016 | All Articles, Technical Analysis

Fear on Tap?

Last week we examined what can be gleaned from measuring fear in the market using the volatility indexes of individual stocks in the S&P 500.

These implied volatility indexes revealed expectations of future volatility. The same volatility indexes are useful to gauge when market moves are at extremes.

But we can do more!

Volatility Seesaw

Let’s take a look at comparing near-term volatility expectations to further-out volatility expectations. To do this we’ll compare the 1-Month Volatility Index for the S&P 500 to the 3-Month Volatility Index. The chart below does this.

(Above: 1-Month Volatility Index for the S&P 500 to the 3-Month Volatility Index)

From here we can see volatility seesaws between near-term being greater (a high ratio) and then further out (a low ratio) and then back full circle. You can see price seesaws around 1.00, which is when they are equal.

But what does it mean, exactly?

When the ratio is far below 1, volatility is expected to be further out – somewhere in the future – but not now. Some call this complacency.

Seesaw

Conversely, when the ratio is far above 1, then near-term volatility expectations are higher.

This is the condition we’ll examine today.

My analysis puts numbers to something in behavioral finance called recency bias. This is the theory that when fear is measurably greater in the near-term, the overreaction may have run its course.

A Word about Recency Bias

Recency bias is one of many cognitive biases we humans have. It’s the tendency to think in certain ways that can, in turn, lead to systematic deviations from a standard of rationality or good judgement. Sound clinical? It is. People with PhDs really get into this.

Simply put, humans are irrational and biased, and tend to be so together in large groups (herd mentality), potentially causing market distortions. These biases poke holes in the academic “efficient markets” hypothesis – which is a fascinating story in itself. I’ll write about it in the future.

Specifically, recency bias is a cognitive error that causes one to think whatever’s happening right now will continue to happen in the future.

This is important, because the markets keep moving but mentally we don’t. Instead, we plant ourselves in the past and think what just happened will continue. In this case something bad and/or painful like a market correction or a period of high volatility.

Slicing, Dicing, and Visualization?

With data, we can examine these relationships. The story they tell helps us overcome recency bias and trade smarter.

So, what is the relationship between our seesaw of fear in the S&P 500?

Let’s examine it visually using Optuma by Market Analyst. We’ll plot the S&P 500 over its Volatility Ratio. It looks like this:

Note the relationship. The majority of the time, the ratio is below 1 and when it’s very high we likely see bottoms in the S&P 500.

It appears that there’s an inverse relationship between price and our volatility ratio.

To see this better, let’s invert the chart of the ratio and zoom in to a smaller time-slice, like the second half of 2014. Remember the ratio is in blue and the S&P 500 in orange.

What happens when the ratio climbs to a high extreme, rather than sinking well below 1?

I’ll look at when the ratio crossed above 1.08. It may sound complicated, but it’s not. Here is the scripting for it in Optuma.

Using the Scripting Language to Create a Custom Tool

This condition can be seen in the bottom pane in the chart below, when the ratio crosses above the dotted green line. Optuma makes it easy to see when this occurred in regards to price by plotting green arrows under the S&P 500.

Observations

The Volatility Ratio crossed above 1.08 thirty times between 2006 and today.

The majority of the time, the ratio reached an extreme near market bottoms. Even in overall down-trending years, such as 2007-2008, the ratio crossing above 1.08 seems to indicate to be on the lookout for a potential bottom.

What have you done for me lately, Volatility Ratio?

Let’s look at the recent environment compared to the rest of the bull market that we’re in currently, from early-2009 until now.

For this example, we’ll assume we’re still in a bull market. The table below shows the recent spikes in 2014 and 2015 both made it into the highest readings since 2009.

Recent volatility spikes in 2014 and 2015

Right now, the ratio is actually under 1. Nowhere near spike territory.

Keep in mind this doesn’t take into account how high the actual short-term and longer-term volatility indexes are – only their relationship to each other.

You could go quite deep with this type of analysis (which we’ll explore on our blog from time to time – so be sure to subscribe to receive each update).

However, if the markets persist to the downside, we now have another volatility extreme measure to watch for clues of a potential turnaround.

Optuma by Market Analyst makes it easy to look at the markets in fresh new ways, combining your ideas with pre-built studies, or testing out something totally new. Stay tuned as we’ll be covering new ways to examine your markets.

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Carson Dahlberg, CMT

Carson Dahlberg, CMT

Author & Co-founder of Northington Dahlberg Research

Carson comes to Optuma bringing nearly 20 years of experience in the financial markets involved in technical and quantitative trading, research and education. Carson has worked for several notable firms: Morgan Stanley, Wachovia Securities, Wells Fargo, and Schaeffer’s Investment Research. In addition, he is the co-founder of Northington Dahlberg Research, a quantitative driven, volatility-based research firm, and was the Director of the CMTinstitute (an online program to assist financial professionals in the passing of the CMT examination process).

Carson is presently a Director at Large on the Board of the Market Technicians Association and serves the Market Technicians Association (MTA) in various capacities. He was the founder and first Chapter Chair of the Charlotte Chapter for the MTA. His involvement with being the Committee Chair for the Ethics Committee has led to an updated and globally relevant ethics offering for the designation. In the past, he has served on the Admissions Committee, was the Board Liaison for the Journal of Technical Analysis Committee, and was the Director of the CMTinstitute.

Carson received a degree in Chemistry from the University of Cincinnati and was awarded the Chartered Market Technician designation in January of 2008.

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