Blog - Investing Notes
Blog Synthesis: Volatility Effects
Reward goes with risk, and volatility represents risk. Therefore, volatility means reward -- investors/traders get paid for riding roller coasters. Right? Well, sometimes yes and sometimes no. Here is a listing of past blog entries related to the volatility effects.
A Market Volatility Factor Model ...evidence suggests that investors may be able to exploit market volatility derived from forward-looking (implied volatility) measures, especially the persistent diffusion volatility component.
Stock Returns and Changes in Implied Volatility ...evidence suggests that investors may be able to gain an edge from the power of changes in implied volatilities to predict returns for individual stocks, and the power of stock returns to predict future changes in implied volatilities.
Volatility and Valuation Ratios ...evidence suggest that investors should consider both the expected the state of the economy and the rareness of that state in in anticipating the relationship between asset class returns and asset class return volatilities.
Varying Leverage for Optimal Long-Term Performance ...evidence from a limited sample period (in terms of number of bull and bear markets) indicates that optimized leverage beats both fixed leverage and no leverage. However, with unlucky initial conditions, even optimized leverage may underperform no leverage over a period of many years.
Extracting the Irrational Part of VIX ...evidence suggests that: (1) VIX may contain an extractable component of irrationally felt risk negatively related to stock returns; and, (2) rational investors may not have fully exploited this relationship.
Shorting Leveraged ETF Pairs ...shorting pairs of 2X and -2X leveraged ETFs may pay off over long periods as rebalancing effects grind on fund values, but data for guiding inference is skimpy and somewhat "wild."
Extreme Days Relative to Bear Market Ends ...evidence from a simple test applied to the last 60 years does not support a belief that extreme days reliably cluster near the ends of bear markets. It does support a belief that extreme days are more likely during bear than bull markets. Results also indicate that the threshold for "extreme" varies over time, complicating the use of extreme days as a signal.
Long-run Stock Market Volatility Based on Reasonable Expectations ...evidence indicates that equity investors continuously acting on reasonable but uncertain expectations may experience much higher return volatilities over the long run than suggested by realized stock market volatility in hindsight.
The Unreliability of Beta ...stock betas calculated from historical data vary considerably over short intervals, across calculation methods and across data sources and therefore may be of little or no value as an investment tool.
The Implied-Realized Volatility Gap as Return Predictor ...evidence suggests that the fear-driven gap between option-implied volatility and contemporaneous realized volatility for a broad stock market index may offer investors/traders a small edge in anticipating near-term stock and bond returns.
The Unintended Characteristics of Leveraged and Inverse ETFs ...leveraged and inverse ETFs bear a potentially material path-dependence penalty, and high transaction costs and tax inefficiency for daily fund re-leveraging, that make them unsuitable as long-term holdings. Daily re-leveraging may have a destabilizing effect on the underlying index near the close.
The Performance of Leveraged ETFs over Extended Holding Periods ...very limited evidence shows that the actual leverages of leveraged ETFs vary considerably from their short-term design values over extended holding periods.
Correlation Variability as Driver of the Volatility Risk Premium ...evidence suggests that equity index options carry a price premium because of their value in hedging against shocks to return correlations among individual stocks. Options for individual stocks do not carry this premium.
The Why of the Volatility Risk Premium ...modeling suggests that sharp jumps in stock market volatility drive investors to overprice some equity index options, most consistently out-of-the-money put options.
The Downside Risk Factor ...evidence weakly suggests that downside risk (downside beta) may be a better indicator of differences in future returns among individual stocks than normal beta.
The Volatility Premium and the Four Factors ...options buyers (sellers) might want to tilt toward stocks with high (low) betas, large (small) market capitalizations, low (high) book-to-market ratios and significant (no) momentum.
The Best Kind of Stocks to Pick? ...stock pickers may want to focus on stocks with high idiosyncratic volatility.
An Alternative Measure of Investment Risk ...gain-loss spread (expected gain minus expected loss) is a simple, intuitive measure of investment risk at least as useful as standard deviation.
VIX and Future Stock Market Returns ...evidence from simple tests does not support a belief that a high (low) VIX or a relatively high (low) VIX reliably predicts future stock market returns or supports a systematic trading strategy as a standalone signal.
The History and Meaning of VIX ...VIX is a roughly mean-reverting and asymmetrical measure of the price of stock portfolio insurance, and that price is empirically reasonable.
Overpaying for Jumpy Stocks? ...evidence suggests investors/traders tend to overpay for stocks with recent extreme positive daily returns, and these stocks therefore subsequently tend to underperform.
A Slinky (Short-term Reversion) Effect? ...extreme market declines (much more than extreme market advances) present reversal trading opportunities with relatively high risk, but these opportunities are by definition infrequent and are very unevenly spaced over time.
Seasonal Environmental Factors and Perceived Risk ...traders may be able to exploit predictable seasonal changes in implied volatility that derive from the effects of investor mood on perceived risk and not from variations in actual risk.
Do Informed Traders Tip Their Hands Via Option Purchases? ...evidence supports beliefs that informed traders distort the relationship between the prices for put and call options on individual stocks and that others may be able to exploit these distortions. Relatively expensive calls (puts) predict stock outperformance (underperformance).
Trend Implications of Big Up and Down Days ...big up and down days appear to have some tendency to cluster, with such volatility clusters associated more with market bottoms than with continuing downtrends.
Misunderestimating Volatility? ...sloppiness in applying statistics can lead to severe misestimates of variability. People should rely on definitions, not intuitions, in assessing volatility.
Sources of Volatility's Predictive Power for Stock Returns ...volatility-based portfolio strategies derive their effectiveness from: (1) the difference between realized volatility and implied volatility ; and, (2) the difference between call-implied volatility and put-implied volatility.
(Low) Volatility as an Indicator of Persistent Hedge Fund Outperformance ...low volatility of returns is key to identifying persistent outperformance among hedge funds.
Short-term Relative VIX Level as a Trading Signal ...the TradingMarkets 5% VIX rule is of limited practical use and does not support a standalone trading strategy that keeps up with buy-and-hold.
The Long and Short of Beta ...stock betas change over time, and strategies that track these changes with high-frequency data can generate abnormal returns. Stocks with long-term high (low) but recently decreasing (increasing) betas are buys (sells).
Low Risk and High Return? ...investors overpay for volatile stocks over the long haul, most dramatically during bear markets.
Fear Factor? ...implied or expected volatility (VIX) should tentatively be viewed as a fifth factor in modeling stock returns because it affects them both directly in a multi-factor model and indirectly through the other risk factors.
Some Notes on Variability of Stock Market Returns ...How should the variability of stock market returns shape the outlooks of short-term traders and long-term investors? How strong is the tailwind of the general drift upward in stock prices? How powerful is the turbulence of variability? Does the tailwind ever overpower the turbulence?
Screening for Fear When Portfolio Building ...the volatility premium for individual stocks derives from volatilities implied by options prices rather than historical (realized) stock price volatilities. This premium may be concentrated in small growth stocks.
Measuring Investor/Trader Risk Aversion ...when investors/traders are depressed, as measured by the gap between implied volatility and historical volatility, so are stock prices.
Risky Stocks + Short Sellers = Low Returns ...high short interest alone does not predict abnormally low future returns. Rather, high short interest for stocks that are particularly risky to trade (high idiosyncratic volatility) predicts low future returns. One interpretation is that, when short sellers take on hard-to-hedge positions, they exhibit stock-picking skill.
A Short-term VIX Trading Strategy That Works? ...VIX signals are useful for short-term switching between small-capitalization and large-capitalization stock indexes, especially when VIX is historically high.
Why Highly Volatile Stocks Tend to Underperform ...the idiosyncratic volatility premium is closely related to the value premium, with low volatility and high value stocks tending to outperform. Insensitivity to discount rate (inflation, interest rate...) shocks is the common underlying factor.
VIX as an Indicator for Different Kinds of Portfolios ...both the long-term and short-term behaviors of the VIX appear to have some value as an indicator of future stock returns, especially for high-beta stocks.
Predicting Stock Returns Not with Volatility, But Volatilities ...when experts cite overall stock market volatility as an indicator of future market behavior, they are only half right, which is about the same as wrong.
No Reward for Risk? Why Can't They Keep Their Story Straight? ...exceptionally volatile stocks are on average inferior investments, or at least trades. There is no reward for this kind of risk, and presently no explanation for this effect.
In summary, high price volatility is generally a good sign for the overall stock market but a bad sign for individual stocks.
