June 08, 2010

Here’s why you are getting sick from the markets

Most average investors have a hard time grasping some of the more abstract concepts such as Market Volatility.  But everyone knows when the market crashes it hurts the portfolio and ultimately your own wallet.  During the financial crisis of 2008/09 the VIX Index, also known as the fear index, was one of the new trendy financial terms you could hear at cocktail parties.  Instead of the talk about the Lakers or the Dodgers, I remember hearing “How about that VIX” at more than a handful of social events in 2009.

So what exactly is this VIX measuring and what is volatility?  You can “google” the word volatility and results along the lines of “annualized standard deviation of daily returns” will pop up. Lingo aside, it is easier to understand the concept with this analogy: A roller-coaster ride and its up and down movements at relatively high speeds is what volatility feels like. That combination of up/down as well as sharp turns at the high speeds is what makes our stomachs turn.  And you typically get more sick in a fast down turn because of the fear of tumbling all the way to the ground.  The VIX expressed that fear of tumbling most vividly in 2008; as the markets were crashing the index for fear was at an all-time high.


Ever since the summer of 2008 however, another dimension has made the most die hard market participants sick to the stomach as well.  It is the intraday price swings which have led to a different kind of shake-out no longer resembling a roller coaster but rather something like this…


The traditional measure of volatility in terms of comparing the daily returns does not fully capture the challenges which have been increasingly similar to skiing down a hill of moguls at high speeds. Best example was the fat-finger flash crash on May 6 when the Dow fell nearly 700 points only to recoup most of the losses by market close.  The S&P500 on that day only dropped 3.2% from the previous day but the intraday price swing, as measured by the difference between High and Low versus the opening price, was a stunning 8.7%. 

Examining the price difference between High and Low relative to the opening price of the market gives us a better view of how things have changed in the markets.  Historically that daily High/Low range has not been nearly as challenging as it was in the past two years.  There were certain spikes, most notably the 20.5% daily range on Black Monday of 1987. However, examining daily data since 1962, we found that 96% of the trading days had a daily price range of no more than 3%.


By contrast, the daily price ranges since 2008 have seen higher oscillations more frequently. A particularly volatile period was between October 1, 2008 and March 31, 2009.  In the 146 trading days during that period, 64% of the time (93 days) showed a daily price range of more than 3%. 


Putting that into perspective, 1987, perhaps mistakenly known as one of the worst periods of the stock market history, saw only 25 days out of the 253 trading days in that year (about 10%) with a daily price range of more than 3%.  While these data bear no reflection as to actual stock market returns, they are clearly an argument towards learning some mogul skiing-type trading skills or alternatively avoiding the bumps altogether.

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