Volatility Effects

The Chicago Board Options Exchange (CBOE) Volatility Index (VIX) gets special attention from investing experts and the financial media as the “investor fear gauge.” What are the origins of VIX, and why was it created? In his November 2008 draft paper entitled Understanding VIX, VIX creator Robert Whaley describes the purpose, history and essential characteristics of this index. Using historical data from January 1986 through October 2008, he explains that: Keep Reading

A rare sighting… Keep Reading

Are investors/traders irrationally attracted to stocks that have recently acted like winning lottery tickets? In their August 2008 paper entitled “Maxing Out: Stocks as Lotteries and the Cross-Section of Expected Returns”, Turan Bali, Nusret Cakici and Robert Whitelaw investigate the significance of extreme positive past daily returns for future returns. Specifically, they examine next-month returns for stocks sorted by maximum daily return during the past month. Using daily and monthly returns, and contemporaneous firm characteristics, for a broad sample of stocks over the period July 1962 thorough December 2005, they conclude that: Keep Reading

Does the degree to which out-of-the-money (OTM) put options are “overpriced” imply future returns for associated stocks? In other words, are options traders especially well-informed? In their March 2008 paper entitled “What Does Individual Option Volatility Smirk Tell Us about Future Equity Returns?”, Xiaoyan Zhang, Rui Zhao and Yuhang Xing test whether option prices for individual stocks contain important information for the underlying equities. They focus on the predictive power of volatility smirks, the difference between the implied volatilities of OTM put options and at-the-money (ATM) call options. Using daily option and underlying stock price data for all firms with listed options during 1996-2005, they conclude that: Keep Reading

Do traders with solid information about firm prospects use equity options to get leverage and avoid short selling constraints? Two recent papers address this question by testing the predictive power of distortions in out-of-the money option prices for individual stocks. In their December 2007 paper entitled “Deviations from Put-Call Parity and Stock Return Predictability”, Martijn Cremers and David Weinbaum examine the power of relatively expensive options to predict returns for individual stocks. In a similar March 2008 paper entitled “What Does Individual Option Volatility Smirk Tell Us about Future Equity Returns?”, Xiaoyan Zhang, Rui Zhao and Yuhang Xing focus on relatively expensive put options as indicators of bad news and poor future returns for individual stocks. Using options pricing and associated stock return data over the period 1996-2005, these two studies conclude that: Keep Reading

A reader offered the following observation and question: “For many market observers, the 200-day moving average is the point of being in or out of the market. Does being above or below the 200-day moving average make a material difference with respect to missing the the best/worst 10, 20 or 100 days?” To check, we return to the data set for our “Trend Implications of Big Up and Down Days”, which identifies the 40 biggest up days (daily return > 3.50%) and the 40 biggest down days (daily return < -3.09%) for the S&P 500 index during January 1950 through November 2007. Calculating the 200-day moving average (MA) at the close for each day just before these 80 biggest up/down days, we find that: Keep Reading

A reader asked:”Do big up days tend to occur during down trends as counter-move rallies (meaning that big down days and big up days tend to cluster during downtrends)?” To check for clustering, we compare the dates of big up and down days for U.S. stock market averages. To check whether these dates tend to occur during downtrends, we examine returns during the 63 trading days before and the 63 trading days after these dates. Using daily returns for the Dow Jones Industrial Average (DJIA) during October 1928 through November 2007 and the S&P 500 index during January 1950 through November 2007, we find that: Keep Reading

Are “intuitive statistics” good enough for investing? In their brief March 2007 paper entitled “We Don’t Quite Know What We Are Talking About When We Talk About Volatility”, Daniel Goldstein and Nassim Taleb report the results of a simple test of the ability of portfolio managers, traders, quantitative analysts and financial engineering graduate students to distinguish between two widely used measures of volatility: mean absolute deviation and standard deviation. Based on responses from 87 individuals to a survey question giving the mean absolute deviation for a normal distribution of stock returns and asking for the standard deviation, they find that: Keep Reading

Past research finds that stocks with low (high) short-term historical volatility tend to outperform (underperform). What causes this relationship? In the November 2007 update of their paper entitled “Volatility Spreads and Expected Stock Returns”, Turan Bali and Armen Hovakimian examine the similarities and differences between realized (historical) volatility and implied volatility in the context of power to predict stock returns. Using stock price/fundamentals data for a broad range of stocks and volatilities implied by associated options with near-term expiration dates over the period January 1996-January 2005, they find that: Keep Reading

Market conditions vary considerably across the business cycle, presumably affecting the opportunity set for a given investing style/strategy. What are the return characteristics that predict which hedge funds can best navigate changing economic conditions? In his 2007 paper entitled “The Sustainability of Hedge Fund Performance: New Insights”, Daniel Capocci decomposes hedge fund returns to determine how investors can reliably identify funds that outperform equity and bond indexes in both bull and bear markets. Using monthly return data for the 1994-2002 business cycle from two sources (3,060 individual funds and 907 funds of funds) to investigate 14 potentially useful persistence discriminators, he concludes that: Keep Reading