Magazine article Modern Trader

Focusing on Volatility for 'Real' Market Trends

Magazine article Modern Trader

Focusing on Volatility for 'Real' Market Trends

Article excerpt

Focusing on volatility for `real' market trends

Protecting corporate balance sheets from increasingly volatile economic conditions requires "a view" on rates or prices. Commercial tacticians strive to find where the dollar, interest rates or copper prices are headed.

Their task might be easier if they'd focus on the culprit itself - volatility. Changes in volatility often presage "real" market trends more usefully than any other market commentary.

What the tacticians really want to know, after all, is what "the market" thinks - information politicians solicit in opinion polls.

Market artifacts such as price and volatility, though only symptoms, often reveal what market users think more clearly than the statements of an isolated few.

For example, when a market is trading above its 18-day moving average, price alone might not supply useful evidence about what will happen next. But if the market trades even higher, historical volatility should also increase. Then, if implied volatility trends higher along with historical, that's evidence the market believes the trend will continue.

In contrast, if the implied volatility remains stable while prices climb, the market apparently thinks the increase can be absorbed and the trend will be short-lived.

A retrospective of Deutsche mark trading offers some specific examples.

In late October 1987, D-marks which had been trading above the moving average most of the month, pushed sharply higher, but the two volatility trends did not move in concert. Historical volatility flattened, then dipped while implied volatility raced from about 7.5 to above 15.

A market with rapidly rising implied volatility - well above any historical volatility - expects an event that may cause a sustainable market change not yet discounted - maybe an employment or other government report or a forecast of dry weather.

Late in April 1988, the market, trading slightly below the moving average, began to fall. At that time, both volatilities dropped sharply. That suggests the market believed whatever triggered the move already had been discounted.

Last November, euphoria over developments in East Germany fueled a D-mark rally. But volatility again decreased. The market seemed more concerned about a variety of political uncertainties and the inflationary potential of the rapidly approaching monetary union than happy about the breakup of "the Wall."

Especially noteworthy here is the implied volatility, which indicates the market had discounted the upside and believed the D-mark would tend toward its average. It priced options accordingly. Since December, the mark has spent most of its time wandering about a 2 [cents] range.

In general, increasing volatility indicates prices will continue to move away from the moving average. Decreasing volatility indicates prices will return to the average.

By mid-July, a little rally seemed to be developing. The key change tacticians need to seek in a case like this is a jump in implied volatility in excess of historical. Should that happen, they can admit confidently to a "strong view" on the D-mark. This volatility development indicates a new trend is in the making.

Past vs. future

The usefulness of volatility as a direction indicator follows because historical volatility provides a statistical estimate of how active a market has been - how far prices have varied from the norm. But implied volatility, in effect, polls traders concerning their view of what is likely to happen.

Details aside, historical volatility tells traders how much price movement is likely in a year. With D-marks trading at $0.60, historical volatility of 9 means there's roughly a 68% likelihood that prices will fall between $0.5460 and $0. …

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