Self Directed Investor Inc
SDI: "Empowering investors with ideas and education"
Symbol Lookup »  
Topics:ChinaETFsEarningsEconomyEnergyForexGoldIncomeLessonsIdeasTrading

  • Other news: News from PR Newswire
| More

Volatility During Crises

Fri, Dec 21, 10:32 AM ET, by Bill Luby

[The following first appeared in the August 2011 edition of Expiring Monthly: The Option Traders Journal. I thought I would share it because it might help some readers put the current fiscal cliff crisis in historical context.]

The events of the last three weeks are a reminder that financial crises and stock market volatility can appear almost instantaneously and mushroom out of control before some investors even have a chance to ask what is happening. A case in point: on August 3rd investors were breathing a sigh of relief after the United States had finalized an agreement to raise the debt ceiling; at that time, the VIX stood at 23.38, reflecting a relative sense of calm, yet just three days later, the VIX jumped to 48.00 as two new crises displaced the debt ceiling issue.

Spanning the globe from Northern Africa, Japan, Europe and the United States, 2011 has seen no shortage of crises in the first eight months of the year. Given this pervasive crisis atmosphere, it is reasonable for investors to consider how much volatility they should anticipate during a crisis. In this article I will attempt to put crises and volatility in some historical perspective and address a variety of factors that affect the magnitude and duration of volatility during a crisis, drawing upon fundamental, technical and psychological causes.

Volatility in the Twentieth Century

Every generation likes to think that the issues of their time are more daunting and more complex than those faced by prior generations. No doubt investors fall prey to this kind of thinking as well. With a highly interconnected global economy, a news cycle that races around the globe at the speed of light and high-frequency and algorithmic trading systems that have transferred the task of trading from humans to machines, there is a lot to be said for the current batch of concerns. Looking at just the first half of the twentieth century, however, investors had to cope with the Great Depression, two world wars and the dawn of the nuclear age.

Given that the CBOE Volatility Index (VIX) was not launched until 1993, any evaluation of the volatility component of various crises prior to the VIX must rely on measures of historical volatility (HV) rather than implied volatility. As the S&P 500 index on which the VIX is based only dates back to 1957, I have elected to use historical data for the Dow Jones Industrial Average dating back to before the Great Depression. In Figure 1 below, I have collected peak 20-day historical volatility readings for selected crises from 1929 to the present.

Before studying the table, readers may wish to perform a quick exercise by making a mental list of some of the events of the 20th century that constituted immediate or deferred threats to the United States, then compare the magnitude of that threat with the peak historical volatility observed in the Dow Jones Industrial Average. If you are like most historians and investors, after looking at the data you will probably conclude that the magnitude of the crisis and the magnitude of the stock market volatility have at best a very weak correlation.

[source(s): Yahoo]

Any ranking of crises in which the Cuban Missile Crisis and the attack on Pearl Harbor rank in the lower half of the list is certain to raise some eyebrows. Frankly I would have been surprised if even one of these events failed to trigger a historical volatility reading of 25, but seeing that was the case for half the crises on this list certainly provides a fair amount of food for thought.

Volatility in the VIX Era

With the launch of the VIX it became possible not only to evaluate historical volatility, but implied volatility as well. With only 18 years of data to draw upon, there is a limited universe of crises to examine, so in the table in Figures 2 below, I have highlighted the seven crises in the VIX era in which intraday volatility has reached at least 48. Additionally, I have included five other crises with smaller VIX spikes for comparison purposes.

[source(s): CBOE, Yahoo]

[Some brief explanatory notes will probably make the data easier to interpret. First, the crises are ranked by maximum VIX value, with the maximum historical volatility in an adjacent column for an easy comparison. The column immediately to the right of the MAX HV data captures the number of days from the peak VIX reading to the maximum 20-day HV reading, with negative numbers (LTCM and Y2K) indicating that HV peaked before the VIX did. The VIX vs. HV column calculates the amount in percentage terms that the peak VIX exceeded the peak HV. The VIX>10%10d" column reflects how many days transpired from the first VIX close above its 10-day moving average to the peak VIX reading. The SPX Drawdown column calculates the maximum peak to trough drawdown in the S&P 500 index during the crisis period, not from any pre-crisis peak. The VIX:SPX drawdown ratio calculates the percentage change in the VIX from the SPX crisis high to the SPX crisis low relative the percentage change in the SPX during the same period (of course these are not necessarily the VIX highs and lows during the period.) The SPX low relative to the 200-day moving average is the maximum amount the SPX fell below its 200-day moving average during the crisis. Finally, the last two columns capture the number of consecutive days the VIX closed at or above 30 during the crisis and the number of days the SPX closed at least 4% above or below the previous day's close during the crisis.]

Looking at the VIX era numbers, it is not surprising that the financial crisis of 2008 dominates in many of the categories. Reading across the rows, one can get an interesting cross-section of each crisis in terms of various volatility metrics, but I think some of the more interesting analysis comes from examining the columns, where we can learn something not just about the nature of the crises, but also about volatility as well. One important caveat is that the limited number of data points does not allow for this to be a statistically valid sample, but that does not preclude the possibility of drawing some potentially valuable and actionable conclusions.

Looking at the peak VIX reading relative to the peak HV reading I note that in all instances the VIX was ultimately higher than the maximum 20-day historical volatility reading. In the five lesser crises, the VIX was generally 50-80% higher than peak HV. In the seven major crises, not surprisingly HV did approach the VIX in several instances, but in the case of the 9/11 attack and the 2010 European sovereign debt crisis the VIX readings grossly overestimated future realized volatility.

One of my hypotheses about the time between the first VIX close above its 10-day moving average and the ultimate maximum VIX reading was that the longer the period between the initial VIX breakout and the maximum VIX, the higher the VIX spike would be. In this case the Long-Term Capital Management (LTCM) and 2008 crises support the hypothesis, but the data is spotty elsewhere. The current European debt crisis, Asian Currency Crisis of 1997 and 9/11 attack all reflect a very rapid escalation of the VIX to its crisis high. In the case of the May 2010 'Flash Crash' and the Fukushima Nuclear Meltdown, the maximum VIX reading happened just one day after the initial VIX breakout. As many traders use the level of the VIX relative to its 10-day moving averages as a trading trigger, the data in this column could be of assistance to those looking to fine-tune entries or better understand the time component of the risk management equation.

Turing to the SPX drawdown data, the Asian Currency Crisis stands out as one instance where the VIX spike seems in retrospect to be out of proportion to the SPX peak to trough drawdown during the crisis. On the other side of the ledger, the drawdown during the Dotcom Crash appears to be consistent with a much higher VIX reading. Here the fact that it took some 2 ½ years for stocks to find a bottom meant that when the market finally bottomed, investors were somewhat desensitized and some of the fear and panic had already left the market, which is similar to what happened at the time of the March 2009 bottom. Note that the median VIX:SPX drawdown ratio for all twelve crises is 10.0, which is about 2 ½ times the movement in the VIX that one would expect during more normal market conditions.

The data for the SPX Low vs. 200-day Moving Average is similar to that of the SPX drawdown. For the most part, any drawdown of 10% or more is likely to take the index below its 200-day moving average. In the seven major crises profiled above, all but the Asian Currency Crisis dragged the index below its 200-day moving average; on the other hand, in all but one of the lesser crises the SPX never dropped below its 200-day moving average. Based on this data at least, one might be inclined to include the 200-day moving average breach as one aspect which helps to differentiate between major and minor crises.

As I see it, the last two columns - consecutive days of VIX closes over 30 and number of days in which the SPX has a 4% move - are central to the essence of the crisis volatility equation. Since the dawn of the VIX, the SPX has experienced a 2% move in about 80% of its calendar years, the VIX has spiked over 30 about 60% of the years, and the SPX has seen at least one 4% move in about 40% of those years. Those 4% moves are rare enough so that they almost always occur in the context of some sort of major crisis. In fact, one could argue that a 4% move in the SPX is a necessary condition for a financial crisis and/or a significant volatility event.

Fundamental, Technical and Psychological Factors in Crisis Volatility

Crises have many different causes. In the pre-VIX era, we saw a mix of geopolitical crises and stock market crashes, where the driving forces were largely fundamental ones. During the VIX era, I would argue that technical and psychological factors become increasingly important. The rise of quantitative trading has given birth to algorithmic trading, high-frequency trading and related approaches which place more emphasis on technical data than fundamental data. At the same time, retail investing has been revolutionized by a new class of online traders and the concomitant explosion in self-directed traders. This increased activity at the retail level has added a new layer of psychology to the market.

In terms of fundamental factors, one could easily argue that the top nine VIX spikes from the list of VIX era crises all arise from just two meta-crises, whose causes and imperfect resolution has created an interconnectedness in which subsequent crises are to a large extent just downstream manifestations of the ripple effect of the original crisis.

The first example of the meta-crisis effect was the 1997 Asian Currency Crisis, which migrated to Russia in the form of the 1998 Russian Ruble Crisis, which played a major role in the collapse of Long-Term Capital Management.

The second example of meta-crisis ripples begins with the Dotcom Crash and the efforts of Alan Greenspan to stimulate the economy with ultra-low interest rates. From here it is easy to draw a direct line of causation to the housing bubble, the collapse of Bear Stearns, the 2008 Financial Crisis and the recurring European Sovereign Debt Crisis. In each case, the remedial action for one crisis helped to sow the seeds for the next crisis.

In addition to the fundamental interconnectedness of these recent crises, it is also worth noting that the lower volatility crises were largely point or one-time-only events. There was, for instance, only one Hurricane Katrina, one turn of the clock for Y2K and one earthquake plus tsunami in Japan. As a result, the volatility associated with these events was compressed in time and accordingly the contagion potential was limited. By contrast, the major volatility events are more accurately thought of as systemic threats that ebbed and flowed over the course of an extended period, typically with multiple volatility spikes. In the same vein, the attempted resolution of these events generally included a complex government policy cocktail, whose effects were gradual and of largely indeterminate effectiveness.

Apart from the fundamental thread running through these crises, I also believe there is a psychological thread that sometimes spans multiple crises. Specifically, I am referring to the shadow that one crisis casts on future crises that follow it closely in time. I call this phenomenon 'disaster imprinting' and psychologists characterize something similar as availability bias. Simply stated, disaster imprinting refers to a phenomenon in which the threats of financial and psychological disaster are so severe that they leave a permanent or semi-permanent scar in one's psyche. Another way to describe disaster imprinting might be to liken it to a low-level financial post-traumatic stress disorder. Following the 2008 Financial Crisis, most investors were prone to overestimating future risk, which is why the VIX was consistently much higher than realized volatility in 2009 and 2010.

While it is impossible to prove, my sense is that if the events of 2008 were not imprinted in the minds of investors, the current crisis atmosphere might be characterized by a much lower degree of volatility and anxiety.

Conclusion

As this goes to press, the current volatility storm is drawing energy from concerns about the European Sovereign Debt Crisis as well as fears of a slowdown in global economic activity. The rise in volatility has coincided with a swift and violent selloff in stocks that has seen six days in which the S&P 500 index has moved at least 4% either up or down - a rate that is unprecedented outside of the 2008 Financial Crisis.

Ultimately, the severity of a volatility storm is a function of both the magnitude and the duration of the crisis, as well as the risk of contagion to other geographies, sectors and institutions. Act I of the European Sovereign Debt Crisis, in which Greece played the starring role, can trace its origins back to December 2009. In the intervening period, it has spread across Europe and has sent shockwaves across the globe.

By historical standards the volatility aspect of the current crisis is more severe than at any time during World War II, the Cuban Missile Crisis and just about any crisis other than the Great Depression, Black Monday of 1987 and the 2008 Financial Crisis.

In the data and commentary above, I have attempted to establish some historical context for volatility during various crises extending back to 1929 and in the process give investors some metrics for evaluating current and future volatility spikes. In addition, it is my hope that concepts such as meta-crises and disaster imprinting can help to bolster the interpretive framework for investors who are seeking a deeper understanding of volatility storms and the crises from which they arise.

Related posts:

Disclosure(s): none


SDI Glossary: "CBOE" Definition
SDI Glossary: "Debt" Definition
SDI Glossary: "Option" Definition
SDI Glossary: "Short" Definition
SDI Glossary: "VIX" Definition
SDI Glossary: "Volatility Index " Definition
This Article's Word Cloud:   Crisis   European   Volatility   about   above   average   below   case   column   crises   crisis   current   data   days   disaster   drawdown   during   events   financial   first   from   fundamental   have   historical   index   investors   just   least   major   market   maximum   more   moving   number   only   peak   period   reading   some   than   that   these   this   time   trading   volatility   were   which   with   would

| More

September 2 Market Update and Daily Stock Scan
Tue, Sep 2, 2:31 PM ET, by Corey Rosenbloom

After a holiday weekend, the market returned with a volatile Tuesday! Let’s chart the broader ...

New eBook on Understanding Options from John Carter
Mon, Sep 1, 2:31 PM ET, by Corey Rosenbloom

John Carter is at it again! This time he’s written a simple eBook entitled “Understanding ...

Answers to the Top Three Questions about Computers for Traders
Fri, Aug 29, 2:11 PM ET, by Corey Rosenbloom

When working with traders, I’m often asked questions about desktop (or even laptops while on ...

August 29 Holiday Update and Stock Scanning
Fri, Aug 29, 1:31 PM ET, by Corey Rosenbloom

While the 2,000 index level is critical to our trading decisions, buyers and sellers continue ...

August 28 Intraday Stock Scan and Market Update
Thu, Aug 28, 1:21 PM ET, by Corey Rosenbloom

Our key focal level for the S&P 500 continues to be the simple 2,000 index ...

Planning Fibonacci Retracement Levels for SP500 and Dow
Thu, Aug 28, 12:11 PM ET, by Corey Rosenbloom

“Always be prepared.” Should the market continue trading down against the 2,000 level in the ...

Stepping Inside the Straight Up Rally for the SP500
Wed, Aug 27, 3:51 PM ET, by Corey Rosenbloom

What does the chart suggest about the current rally into 2,000 and what can we ...

Join Corey Wednesday for a Special Five Steps to a Reversal Webinar
Tue, Aug 26, 1:11 PM ET, by Corey Rosenbloom

I’m excited about a webinar opportunity I’ll present for you Wednesday as part of Trader’s ...

Charting Three Top Trending Stocks to End August
Tue, Aug 26, 11:11 AM ET, by Corey Rosenbloom

I’m a big fan of the concept of “Strong Getting Stronger,” and three such stocks ...

Current Market Rally Echoes a Pattern from the Past
Tue, Aug 26, 10:41 AM ET, by Corey Rosenbloom

If you look closely at the current market rally, you may see something eerily familiar. ...

Bearish Engulfing Opportunity in Altera ALTR
Mon, Aug 25, 2:31 PM ET, by Corey Rosenbloom

Altera (ALTR) showed up on two of my stock scans this morning and I wanted ...

August 25 Breakout Market Update and Stock Scan
Mon, Aug 25, 1:41 PM ET, by Corey Rosenbloom

Well there we have it! It’s official – the S&P 500 achieved the 2,000 Magnet ...

Charting Apple AAPL Through the 100 Dollar High
Fri, Aug 22, 12:11 PM ET, by Corey Rosenbloom

Last week I posted about “Open Air” and magnet levels in Apple – let’s update ...

August 21 Stock Market Update with Trending Stock Scan
Thu, Aug 21, 2:11 PM ET, by Corey Rosenbloom

As we continue yet another trend day to the upside, let’s highlight the price action, ...

Color Keltner Channel Chart into Highs for SP500 and NASDAQ
Thu, Aug 21, 1:11 PM ET, by Corey Rosenbloom

Sometimes it’s helpful to look at one indicator at a time, and we can do ...

Triangle Breakout Triggering for USDJPY Dollar Yen
Thu, Aug 21, 12:11 PM ET, by Corey Rosenbloom

FOREX traders – or those who simply monitor currencies as part of an intermarket picture ...

Hidden Trading Opportunities from August 20 Consecutive Close Scan
Wed, Aug 20, 6:51 PM ET, by Corey Rosenbloom

Sometimes the simplest scans can provide stock candidates to trade that we otherwise may never ...

Up Up and Away for the US Dollar Breakout
Wed, Aug 20, 3:31 PM ET, by Corey Rosenbloom

With stocks breaking out, it may be a surprise that the US Dollar Index is ...

Studying the Repeat Pattern that Targets New Highs for SP500
Wed, Aug 20, 2:11 PM ET, by Corey Rosenbloom

I’ve been posting frequently about the potential “Repeat Pattern” in the S&P 500 that charts ...

Up Up and Away for Home Depot HD Breakout
Tue, Aug 19, 11:31 AM ET, by Corey Rosenbloom

On better than expected earnings, retail stock Home Depot (HD) gapped higher, breaking to all-time ...

August 18 Breadth and Stock Scan Market Update
Mon, Aug 18, 2:41 PM ET, by Corey Rosenbloom

Our mid-day update takes place on yet another bullish trend day higher as price breaks ...

Intraday Divergence and Reversal Planning for Crude Oil
Mon, Aug 18, 2:11 PM ET, by Corey Rosenbloom

Crude Oil may be forming an intraday reversal pattern – with divergences – off an ...

NASDAQ Breaks to New Highs on Relative Strength
Mon, Aug 18, 12:11 PM ET, by Corey Rosenbloom

If you’re an S&P 500 or Dow Jones only trader, you may be missing the ...

Uncovering a Hidden Value Area for Apple AAPL Shares
Fri, Aug 15, 3:41 PM ET, by Corey Rosenbloom

What are our Color Value Area Charts revealing about a key magnet price area to ...

Interesting Breadth Chart for August 15 Intraday Stock Scan Update
Fri, Aug 15, 2:11 PM ET, by Corey Rosenbloom

We don’t usually have exciting Sector Breadth Charts to show but today is an exception. ...

Planning a Larger Reversal or Another Trap for Corn Traders
Fri, Aug 15, 12:41 PM ET, by Corey Rosenbloom

Even if we don’t trade commodities, it’s helpful to learn educational lessons and plan trades ...

Decision Point into Resistance for the Dow Jones
Fri, Aug 15, 12:11 PM ET, by Corey Rosenbloom

The Dow Jones faces a major decision point into a known resistance cluster – monitor ...

Unique Educational Fundraiser All Day Webinar Event for Toni Hansen Saturday
Thu, Aug 14, 3:41 PM ET, by Corey Rosenbloom

I’m both pleased and humbled to announce an all-day event of educational webinars from top ...

August 14 Trend Day Intraday Update and Stock Scan
Thu, Aug 14, 3:21 PM ET, by Corey Rosenbloom

We have another Trend Day on our hands as price once again gaps higher and ...

SP500 Decided to Break On Through to the Other Side
Thu, Aug 14, 12:31 PM ET, by Corey Rosenbloom

Not to be spooked by a little retracement in the market, the buyers (bulls) decided ...

Is the the Breakout You've Been Waiting for in Coal? KOL
Wed, Aug 13, 2:11 PM ET, by Corey Rosenbloom

I’m seeing increased chatter about Coal stocks and ETF KOL regarding a potential breakout and ...

August 13 Intraday Stock Scan and Market Update
Wed, Aug 13, 1:31 PM ET, by Corey Rosenbloom

We started the day with an up-gap and have seen a Trend Day ever since. ...

Instant Intraday Market Internal and Fibonacci SP500 Update into Key Level
Wed, Aug 13, 12:21 PM ET, by Corey Rosenbloom

Let’s take a quick look at our ongoing intraday Fibonacci Grid along with key Market ...

Introducing the 10 Gappiest Stocks in the SP500
Tue, Aug 12, 3:31 PM ET, by Corey Rosenbloom

What’s a “gappy” stock and once we figure that out, which stocks are the ten ...

Updating Our Market Structure Color Charts for SP500 Dow and NASDAQ
Tue, Aug 12, 10:41 AM ET, by Corey Rosenbloom

Let’s take a quick moment to update our “Market Structure” Color Charts for the Big ...

Plotting Reversal Signals for Stocks Oil and the Dollar
Tue, Aug 12, 10:11 AM ET, by Corey Rosenbloom

A quick look at the intraday charts of the S&P 500, Crude Oil, and the ...

August 11 Daily Update and Stock Scan
Mon, Aug 11, 1:11 PM ET, by Corey Rosenbloom

We started the day with an up-gap and have seen a Trend Day ever since. ...

Plotting and Planning a Breakout in Priceline PCLN
Mon, Aug 11, 12:21 PM ET, by Corey Rosenbloom

High-flying stock Priceline (PCLN) triggered a bullish breakout signal this morning with a thrust above ...

Game Planning the SP500 with a Repeat Pattern
Mon, Aug 11, 12:11 PM ET, by Corey Rosenbloom

I wanted to highlight a “Repeat Pattern” in the S&P 500 that can help us ...

Sector Rotation Update and Charts for August 2014
Thu, Aug 7, 10:11 AM ET, by Corey Rosenbloom

What are Sector Rotation Charts hinting about the hidden strength (or weakness) of the broader ...

Opportunities from Stocks Most Extended from 200d SMA August 2014
Tue, Aug 5, 10:21 AM ET, by Corey Rosenbloom

Which stocks are most over (and under) extended from their 200 day SMA? How can ...

Groupon GRPN Pushing for Breakout Reversal
Mon, Aug 4, 11:41 AM ET, by Corey Rosenbloom

Groupon shares (GRPN) may be setting up a potential breakout and bullish trend reversal trade. ...

Simpler Stocks Webinar on Trading ETFS for Profit and Protection
Fri, Aug 1, 8:31 PM ET, by Corey Rosenbloom

John Carter is launching a new, specific venture for you entitled “Simpler Stocks” as a ...

New Fibonacci Reference Grid and Color Arc Structure Chart for SP500 Dow and NASDAQ
Thu, Jul 31, 1:11 PM ET, by Corey Rosenbloom

With the breakdown under the key “Arc Trendline” Structure pattern in the Dow and S&P ...

Market Finally Falls - a Check on the New SP500 and Dow Jones Levels
Thu, Jul 31, 12:21 PM ET, by Corey Rosenbloom

It’s good when logic trumps irrationality, and price retraces in a stable uptrend instead of ...

Updating the Creeping Correlation in Stocks and Bonds SPY and TLT
Wed, Jul 30, 1:51 PM ET, by Corey Rosenbloom

If you’re not paying close attention, you may be missing the stealthily increasing positive correlation ...

Signs of Life from a Breakout in US Steel X
Wed, Jul 30, 1:11 PM ET, by Corey Rosenbloom

Is it possible that US Steel (X) is finally catching a bid from a breakout ...

Midday Market Update and Stock Scanning for July 29
Tue, Jul 29, 2:31 PM ET, by Corey Rosenbloom

Price provides a choppy Range Day environment for traders ahead of tomorrow’s “Fed Day” announcement. ...

Is PLUG Setting Up Another Breakout Run to the Highs
Tue, Jul 29, 11:31 AM ET, by Corey Rosenbloom

Former high-flyer Plug Power (PLUG) could be setting up another bullish breakout and run for ...

Are You Following this Stellar Parabolic Arc in INTC
Tue, Jul 29, 9:51 AM ET, by Corey Rosenbloom

If you haven’t charted or traded Intel (INTC) in a while, you’re missing an amazing ...

  More articles:  1 2 3 4 5 6 7 next »

ABOUT US »   ADVERTISE »   CONTACT US »   TERMS OF USE & PRIVACY POLICY »

Volatility During Crises | Self Directed Investor | Copyright © 2008 - 2014, All Rights Reserved

Any ideas and opinions presented in Self Directed Investor content are for informational and educational purposes only, and do not reflect the opinions of BNK Invest, Inc. or any of its affiliates, subsidiaries or partners. In no way should any content contained herein be interpreted to represent trading or investment advice. None of the information contained herein constitutes a recommendation that any particular security, portfolio, transaction, or investment strategy is suitable for any specific person. All site visitors agree that under no circumstances will BNK Invest, Inc,. its subsidiaries, partners, officers, employees, affiliates, or agents be held liable for any loss or damage caused by your reliance on information obtained. Read Full Disclaimer.

SDI is associated with: ValueForum.com -- a subscription-based online social networking forum of over 1000 individual investors. | MarketNewsVideo.com -- videos appearing on SDI are produced by Market News Video. | TickerTech.com -- stock quote content appearing on SDI is at least 20 minutes delayed and is powered by Ticker Technologies. | GoldStockStrategist.com -- Edited by Scott V. Nystrom, PhD, Gold Stock Strategist provides analysis on gold mining companies.