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Volatility’s Back: Who’s Gonna Be In Trouble?

10 September 2007 at 12:56 pm by Gary Gordon     Bookmark and Share    Follow EtfExpert on Twitter

You’ll hear it mentioned in the news whenever the market falls. And when people get scared, you’ll hear media pundits kick it around the airwaves like a hacky sack.

But what the heck is "volatility?" Is it bad? Is it good?

In plain-speak, volatility is how fast stock prices move. When the stock market is calm and moving in a quiet range… or even heading mildly higher… one might say that volatility is low. In contrast, markets that move up and down erratically usually have large intra-day price swings. (Oh… that volatility.)

Here’s an example that caused a few irregular heartbeats. On 8/16 this year, the Dow waffled throughout the trading day — 150 points down, 300 points down, 150 points, down 300 points down, 150 points down, "even steven." The market was all over the map… mostly on the down side.

So the first reaction to the word itself is that "things must be bad." However, volatility actually helps ETF investors spot opportunities.

In the chart below, we can look at the movement of the popular volatility measure (VIX). We can see that whenever the VIX spikes higher, and whenever it rises rapidly, stock prices tend to decline. We know this because stocks struggled in early March when the VIX spiked to 19.0, and stocks have struggled more recently, ever since the Dow hit 14000 in mid-July.

Vix_volatility

(The VIX crept up above 20.0 in mid-July. It hit 30.0 on August 15. Then, the VIX hit a 52-week intra-day high of 37.0 on August 16.)

Yet stock markets frequently gain remarkable ground after the VIX does something "unusual." For instance, when the volatility measure spiked from a 10.5 low on Feb 26 to an intra-day high of 19.0 on Feb 27, markets sold off dramatically. Yet the VIX moved steadily down over the next 3 weeks towards 12.1, and the markets surged shortly thereafter.

It follows that spikes in volatility such as these create opportunity; that is, ETF investors were able to grab up bargain prices by March 21 as fears began to subside.

The VIX (volatility measure) actually measures fear. And when fear comes out of nowhere in a big spike, stock prices get hammered. Yet that "hammering" is usually a buying opportunity if the VIX settles down.

There’s another important way to look at the VIX that has more to do with the overall trend itself. In August, for instance, we witnessed the VIX go from the 30.0 level (before the Fed cut the discount rate) back down to the 20.0 level. However, it is climbing steadily once again, recently breaching 25 and closing today near 28.

What does this probably mean? It means that there’s still a great deal of fear and uncertainty, mostly centered on the consumer/borrower/employee’s ability to contribute to economic growth.

How can one profit from this knowledge? Short-term traders may consider shorting consumer discretionary spending with the UltraShort Consumer Services ProShares (SCC). This investment is not for the the faint of heart, yet it will likely remain profitable as long as the VIX is climbing over time.

Consumer_scc

At the same time, I would be prepared to exit the UltraShort Consumer Services ProShares (SCC) if the VIX suddenly spiked. Remember, a spike often represents the last bit of fear shaken out of market participants. A VIX that spikes, and then trends lower, usually represents buying opportunities.

Disclosure Statement:  As a Registered Investment Advisor, Pacific Park Financial, Inc. may hold positions in the ETFs, mutual funds and/or index funds mentioned above. Investors who are interested in money management services may visit the Pacific Park Financial, Inc. web site. 

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