Investors tend to think that, overall, low volatility is “good” and that high volatility is “bad”.
In reality, in times of high volatility, emotion plays such a huge role in investors’ decisions that they actually force the market to lower levels than its fair value indicates. In times of low volatility, investors are convinced that the market cannot fall to lower levels, forcing it upwards as has been happening over the past 12 months.
As an indicator, volatility can be used not only to determine risk, but also to identify possible investment opportunities and danger zones. It is not, however, a directional indicator.
An excellent tool to use when gauging volatility is the volatility ratio (VR), a measure through which the price changes of an asset, whether up or down, are expressed as a percentage.
If share A’s price rises from 100c to 101c, for example, this would indicate a positive change of one percent.
If share B’s price falls from 200c to 198c, it would indicate a negative change of 1 percent. The VR (of one percent) of both these shares is the same, which means that the VR of share A is equal to the VR of share B.
If a particular share has a VR of 20, it means that its price has moved up and down by 20 percent over a particular period.
As a result, by buying this share, you don’t only stand the chance of 20 percent growth on your investment, you also risk losing 20percent of its value.
In the US, when trying to predict which way the market will go, investors look at what is colloquially referred to as the fear index or the fear gauge. This is the VIX, a popular measure of the implied volatility of S&P 500 index options. It is calculated and published by the Chicago Board Options Exchange.
Each time that the volatility index (VIX) of the Chicago Board Options Exchange moved to levels above 45, the US market was always regarded as completely “oversold” and correspondingly, was seen as the greatest buying opportunity in the market ever.
It remained that way until it moved back down to the perceived “saturated” levels of around 10, which indicated a possible turning point in the market to investors.
The last time that our market reached a VR of around 10, was shortly before the great correction of 2008 and we all know how that ended: with a near 50percent decline in dollar terms.
Recently, the S&P 500 Index made history. For 105 consecutive trading days, for the first time since 1995, the index did not see a decline of one percent or more.
At the same time it has brought the VIX back to the same levels as in 2008.
Schalk Louw is the principal at PSG Wealth Old Oak.