We recently attended a market structure conference that had a panel entitled: “Market Volatility – August/September 2011 and the May 6th Flash Crash – Have We Instituted the Right Measures? Are they Working?” Besides the observation that the person who titled the session needs to use less words, we discovered that regardless of the answers to the questions posed, the underlying assumption from the panel members was the markets are more volatile now than they were in the past. As a person who formerly sat on a trading desk, our contrarian antennae rose and we set out to see if this assumption could stand further scrutiny (this endeavor did not come without certain risks, as one of the panel members has a strong say in my career at NYSE Euronext).
We will present our evidence via a series of blogs, which will cover multiple ways of looking at volatility. For those of you that prefer the executive summary version:
- The recent spate of large day-to-day price changes is not exceptional compared to past history.
- However, there have been more periods of increased historical volatility since 2000, relative to the prior 40 years.
- Intraday volatility on average is up since Reg NMS, although surprisingly, late-day volatility has actually not been high for 2011 as a whole.
These highlights point out the following:
- Although intraday and by some measures longer term volatility is arguably higher now than it has been in the past, the recent periods of increased volatility have coincided either with major changes to market structure (decimalization, Reg NMS) or periods of extreme fundamental change and/or risk (the Internet Bubble from 2000-2002, the Housing/Credit Crisis during 2008-2009 and the recent issues around the U.S. credit rating and European debt crisis). All of these, except for the Internet Bubble, have entailed heightened risk of full global monetary and credit market meltdowns accompanied by actual or risk of bankruptcies of major banks and investment banks (not to mention risk of sovereign defaults).
- The fact that the increased volatility appears to centered around fundamental crises makes it much more difficult to place blame on the normal bogeymen, such as High Frequency Trading (HFT) and leveraged Exchange Traded Products (ETPs).
What is Volatility?
There are many definitions of volatility. Commonly used versions of volatility include historical volatility, which is essentially the standard deviation of returns over a time period. Implied volatility is the estimate of a security’s price volatility based on an option pricing formula. One can also look at volatility by measuring how prices move during a given period – day to day price changes for example, or even trading ranges over different time periods. We will develop several of these to help us determine whether volatility is truly higher now than it was in the past.
There is no one all encompassing volatility measure, and we could choose any single number to argue that volatility is either up or down in recent years. We have chosen therefore to survey multiple ways of representing volatility in an attempt to answer our title question.
Daily Changes in the Dow
Our first pass at this question initially shows that if you measure volatility merely as the likelihood that the Dow Jones Industrial Average has moved by a certain discrete amount (we used at least 1%, 3% and 5%), that the activity since the start of August 2011 is not at all exceptional.
The percentage of days that had a 3% change, up or down, in the Dow in August and September 2011 was just 9%. There have been 70 two-month rolling periods with a higher incidence of 3% moves since November 1928. However, if we look at the 70 months with higher incidence, there is a clear over representation of months since 2000, and especially since 2007 in that sample.
There is no way however, to come to the conclusion that this inkling of larger price changes since 2007 is due to changes in equity market structure. The global, and especially the U.S. financial system was on the precipice of collapse for much of 2008 and 2009, while European markets have seen historic levels of risk in the past few months.
|% of Days with 3%+ Dow Changes|
|Sep. 2011||(includes August)18% (72nd)|
Part Two of our article will cover the evidence from three additional daily measures: Historical Volatility, VIX and Daily Trading Ranges.
Part Three will cover different ways of looking at Intraday Volatility.
Part Four will relate how market liquidity and volatility are related and will offer our conclusions.