How to anticipate market volatility

The recent market volatility has taken some traders by surprise, coming on the heels of one of the least volatile periods in the past decade. Active traders are vitally concerned with market volatility, because this defines the movement in equities, which in turn provides opportunity for directional trading. If we can anticipate market volatility, we can gauge the amount we can likely take out of trades, as well as the amount that trades might go against us. All things being equal, a busy, volatile market will provide more tradable swings than a slow, non-volatile one.

Just knowing past price ranges and changes can help us assess near-term future volatility, because volatility (unlike price change) tends to be correlated from one period to the next. For example, since October, 2003 (N = 670 trading days) in the S&P 500 Index (SPY | Quote | Chart | News | PowerRating), we have had 61 days in which the high-low range has exceeded 1.5%. The average trading range the following day has averaged 1.11%. That is appreciably wider than the average range for the rest of the sample: .94%. When the previous day's range has been below .50%, the next day's range has averaged only .83%.

The size of the market's overnight range also affects the coming day's volatility. As I recently noted on my TraderFeed research blog, large overnight moves are associated with greater movement during the trading day. This is probably because fundamental economic or political events are roiling overseas markets, creating lingering impacts for American traders. For instance, when the overnight move in SPY has been greater than .50% (N = 55), that day's trading range has averaged 1.15%, wider than the average range of .94% for the rest of the data sample. As a point of reference, in the current market, this difference would amount to 2.5 S&P points.

The absolute value of the VIX (VIX | Quote | Chart | News | PowerRating) at the market open also appears to be related to the size of the day's trading range. When the opening VIX has been 17 or above (N = 97), the day's range has averaged 1.11%, wider than the average range of .93% for the remainder of the sample. When the opening VIX has been below 12 (N = 128), the day's range has only been .79%.

We've been seeing healthy overnight moves and daily ranges--as well as elevated VIX levels--during the past week. That bodes well for market movement in the near term.

Brett N. Steenbarger, Ph.D. is Associate Clinical Professor of Psychiatry and Behavioral Sciences at SUNY Upstate Medical University in Syracuse, NY and author of The Psychology of Trading (Wiley, 2003). As Director of Trader Development for Kingstree Trading, LLC in Chicago, he has mentored numerous professional traders and coordinated a training program for traders. An active trader of the stock indexes, Brett utilizes statistically-based pattern recognition for intraday trading. Brett does not offer commercial services to traders, but maintains an archive of articles and a trading blog at www.brettsteenbarger.com and a blog of market analytics at www.traderfeed.blogspot.com. His book, Enhancing Trader Development, is due for publication this fall (Wiley).