Putting Volatility Into Perspective

Up more than 400 points on the Dow Industrials! Down about 300 points the next day, and then up almost 300 the next. That was the trading pattern just a few days ago. The nightly news anchors were marveling at the dizzying swings in the markets.

The magnitude and frequency of the gyrations appeared to be unprecedented. It was widely taken as a sign of an out-of-control market, one that was headed for disaster. The huge volatility was being interpreted as just another indication of the loss of reason that was apparently gripping the markets.

But is it really unprecedented, and is it really saying that disaster lies ahead? Taking a look at the data, perhaps the message is a little different from the popular reaction. I wanted to take a closer look.

In order to better see what is happening, I wanted to find a way of viewing the data objectively and graphically. To do so, I went back to an indictor that I developed and have used and followed for years.

The work that follows is a modification and expansion of that indicator. It is extremely simple and straightforward. Moreover, it is based on logic, rather than being just a series of numbers that seems to fortuitously work well as a predictive tool. It is so simple and logical that I went back into the literature, looking for similar work and was not able to find any. It must exist, but I did not find it.

In order to see how volatile the market is, an elementary way of looking at it is to ask how far the Dow is swinging, whether plus or minus on each day, and running some sort of moving average to smooth the data. Shown below is a portion of the Excel spreadsheet I developed.

Click here for larger image.

The second column shows the close of the Dow for each date in the first column. The third column is merely the net change for the day; the number you hear in the media as what happened that day. But, as we will rationalize below, we do not care what direction it moved, just how much it moved.

So we create the next column, which is the absolute value for each day (ABS CHG) All we really have done is asked Excel to express each day as a number, ignoring direction; in other words the absolute value for that day.

But the net change for each day can be misleading, because its importance is a function of the level of the Dow. A change of 100 points with the Dow at 1000 is far different from a change of 100 points when the Dow is at 12,000. So we create the next column, in which we divide the day's change by the level of the Dow and multiply by 100. That gives us the absolute percentage change for the day; the absolute percentage change, or APC.

Finally, in order to get a more legible picture, we calculate a 10-day moving average of the APC. That, the last column, becomes our indicator. The last entry, for March 20, shows us that for the day, the APC was 2.11%, and the 10-day moving average of the APC was 1.64%.

Then we graph the results and set then against the Dow itself. Here is a picture of the last seven-plus years. The black line is the Dow; the blue line is the 10-day APC.

Click here for larger image.

Wow! Look at those peaks and troughs. It is apparent that huge volatility is not unique to this market, and that huge volatility is associated with bottoms, not tops. The implication is that when we see immense volatility, it is not telling us it is time to sell, it is telling us it is time to buy.

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At time of publication, Arms had no positions in the stocks mentioned.

Richard Arms is a renowned stock market technician who invented the Arms Index (often referred to as the TRIN), which has become a mainstay of market analysis, appearing in The Wall Street Journal and Barron's. Arms also developed the widely used technical method Equivolume Charting. Since 1996, he has been publishing the Arms Advisory newsletter for money managers and financial institutions. He also has authored Stop and Make Money: How to Profit in the Stock Market Using Volume and Stop Orders, Profits in Volume, Volume Cycles in the Stock Market, Trading Without Fear and The Arms Index, and has been honored with the Market Technicians' Award for Lifetime Contribution to Technical Analysis. Under no circumstances does the information in this commentary represent a recommendation to buy or sell stocks. Richard appreciates your feedback; click here to send him an email.

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