Monday, July 13, 2009

What Happens After A Sharp Contraction In Volatility

I did a study looking at situations where historical volatility has contracted rapidly like it has in the last 3 days. For the study I looked at the 3-day historical volatility and compared it to the 10-day historical volatility 3 days ago. In other words I divided Friday’s 3-day historical volatility by Tuesday’s 10-day historical volatility. A result below 1 would indicate the last 3 days have been less volatile than the previous 10. A number above 1 would indicate a recent uptick in volatility. For the SPX, Friday’s 3-day over Tuesday’s 10-day came in at a very low 0.23.

I then looked to see what the 3-day historical volatility has typically been 3 days later. What does a sharp contraction over the last 3 days indicate you might expect over the next 3 days? What I found is that when the 3-day over the offset 10-day dropped to 0.25 or lower the next 3 days were 5.5 times as volatile as the recent 3 days. This is based on 1,111 trading days since 1960 – or about 9% of all trading days. Going back to just 1999 gave similar results, as the 3-day historical volatility increased by 5.4 times.

This suggests we may see some increased movement over the next few days. A breakout of the recent 3-day range could be very sharp.


Daniel said...

SPY is not going to boinga boinga btw 87 and 93 forever. It will break the range with such force that all who have been predicting a strong move, after so long a sideways period, will be proved right.

I never allow myself to forget the famous (infamous) Barron's article from January 1973 entitled "Not a Bear Among Them". All the pundits in their little survey had positive expectations, and for convincing reasons.

It was a very significant top.

Right now, EVERY financial observer I respect is convincing me, for a variety of good reasons, that the Market has noplace to go but down.

X over there is convincing me on fundamental grounds, Y is showing clear momentum rollovers, Z points out heightened earnings expectations raising the ‘surprise’ bar. Even Q. himself, here, is slightly bearish, for very sound reasons.

Only problem is, there's "not a bull among them".

And we are more oversold than overbought, so is it possible that the sharp move hinted at by Rob's study will be a blowout to the upside...?

I think this is a real danger for bears and hope for bulls.


Jeff said...

I like your study. Where did you get the 10 day vol and 3 day vol from and how do I do this for myself?


a said...

Your study is interesting because it seems in line with the info I have using implied Volatility plus the VIX futures premium with blended two front months which is now a whopping 3 points over VIX IV giving a total of approximately 10 points over HV.

This falls in line with your study 0f 4 out of 5 times accuracy which goes back to when VIX futures started trading in 2004

a said...

Oh I the study I mentioned meant to say it followed in a decline in the S&P

Abbington Funds said...
This comment has been removed by the author.
Anonymous said...

Hello a,
Do you mean to say 'followed "by"'? I don't understand your grammatical construction when you composed you last sentence, "followed in".

Specifically, are you trying to say that event is bullish or bearish? Sorry, it just isn't clear from the writing.

Anonymous said...


What were returns like going forward when volatility resolved with a move higher out of the range ? Thanks

Dave Appel

Daniel said...

Interesting, apropos observation, this morning, from your colleague, Dr. Brett-- Rob, you've probably seen it, but other readers on this blog might not:

"Yesterday we had the strongest day in the last 20 trading sessions; it was also the highest volatility day in SPY over the past 20 days.

Since 2000, when that's happened, we've been up the next day 16 times, down 9 times. Not a significant bullish edge, but certainly not a bearish one."

Bollinger Bands are narrowing. Which direction will the watermelon seed squirt when the sideways pressures are resolved? My educated guess is UP-wards, at least to the top of the recent extended trading range.

Anyone seen the number of Rydex Fund Family bears lately? Gadzooks they're breeding like rabbits, there are zillions of them! Where were they on June 11...?


Daniel said...

"A breakout of the recent 3-day range could be very sharp."

-- Looking back on the week past, this was EXCELLENT guidance Rob!

I think 'SHARP' is a pretty accurate description.