Saturday, May 16, 2009

Heightened Volatility=More Risk=Potential for Lower Prices to Compensate for the Increased Risks

Since I view my discussions of volatility to be far more important than any other topic, I need to add a few caveats for the reader.

If someone asked me to explain the mathematical equations used by the CBOE to calculate the VIX, I could not do it.  My last math course was in high school.  In fact, I have mentioned in  this blog that I decided to go to Tulane in 1969 almost entirely due to Tulane allowing a student to forego Calculus and to substitute philosophy in its place.  I can do philosophy.

I have also never read an economic textbook in my life.  Though, if I was going to start one today, it would probably be one by Fredrich von Hayek, who said in his acceptance speech for the Nobel Prize in Economics that economists have made a mess of things.    Readers of this blog know that economists are a frequent topic, and not always presented in a favorable light.  Actually, I do not remember making a positive comment. 

So, when I discuss the VIX, I am talking about an indicator that has proven itself to have value as a timing tool.  As a person who has traded stocks for decades, I understand the connection between volatility and risk, and I know both intuitively and through experience that enhanced volatility in an individual security, whatever it may be, is proof to me at least of increased risk.  Several of these posts deal with my management of risk by attempting to use volatility in my favor, a very difficult at times task.  I understood that ISF at $4.6, and the volatility it was showing both up and down, was signaling an enhanced risk to the security and the need for a devaluation in its price to compensate for that risk.  The issue is whether at any given point in time whether that volatility in the price was rationally pricing the risk.  I would submit that a price below $3 was not consistent with the risk.  Buy of 50 JZV at 9.93/Movement in Aegon and ING Preferreds: More of A Reflection on the Human Psyche

So as a trader of stocks with experience under my belt, I already understand the connection between price, volatility and risk.  When the VIX pattern revealed itself to me, I was open minded about what it was saying.  Low levels of volatility in the VIX, meaning consistent movement below 20, are conducive to higher stock prices. When that calmness is shattered and fear sets in, probably a very rational fear based on events unfolding in the real world, stock prices become unstable and start to fall, the VIX rises, and the risk of owning stocks increases.

There is also a very high negative correlation between the movement of the VIX and the S & P 500 average. VIX goes up, the index goes down; the index goes up and the VIX goes down.  I would be interested to know the negative correlation statistic on days where the market moves more than 1% either way.  I am just observing the relationship.  That correlation manifests itself in the bull and bear pattern shown in the VIX chart.   

I have also made the point that humans do not appear to me to make investment decisions by taking the long view, and there does appear to be a tendency to project the present, whether good or bad, into the indefinite future.  
So maybe a short term index for volatility does measure the way humans make pricing decisions about the future now. 

It is hard for me to argue with anything that works that has a rational basis to me at least as to why it will work as an indicator, at least until something in human behavior upsets the relation between the VIX and directional stock movement in cyclical bear and bull patterns.  

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