Volatility in the stock market has a direct impact on stock performance and annualized returns. Historically, when market performance is positive, volatility will tend to decline. Conversely with higher volatility, investors experience greater risk, while the market sees a decrease in returns. With the current calmness of the stock market, we have to wonder how long the market will sustain its low volatility, and when we should be concerned.
Volatility is measured by the VIX, a ticker symbol on the Chicago Board Options Exchange (CBOE) that represents the level of expectations for volatility for the next thirty days, and is also known as the “fear gauge”. The VIX is a factor of the volatility of various S&P 500 index options, which is a stock market index that is derived from the capitalization of 500 of the largest companies listed on the New York Stock Exchange (NYSE), and Nasdaq.
The VIX is viewed by many as an indicator of the US economy, and is one of the most followed equity indices.
VIX Hits Lowest Levels in 23 Years
The record low for the VIX occurred on December 22, 1993 when it reached 9.31. For comparison, the historical average of the VIX is about 20, while this ratio has recently been averaging under 10. On July 21, 2017, the VIX hit a near record low when it closed at 9.36, the lowest in over 23 years.
Typically, we see the stock market perform well during such low volatile times. That is certainly the case today, although one might wonder if this fear index is actually in line with the confidence of investors? In spite of the political turmoil we see on a daily basis, and the uncertainty it brings, it appears that investors haven’t yet gotten the memo to be concerned or wane in their confidence.
Factors Affecting Stock Market Volatility
Reactions to news of mergers and acquisitions often cause ripples of activity in the market, although they’ve not been significant enough to jolt the currently quiet market. For example, Sears recently announced in July of 2017 that they will sell their Kenmore appliance line directly through Amazon. This news gave the decreasing shares of Sears a 13% boost, while Home Depot and Lowes experienced about a 5% decrease. These reactions will come and go, but nothing seems to be large enough to wake the sleepy market yet.
Fewer Stocks in the Market
With mergers and acquisitions comes larger business conglomerates. In spite of Antitrust laws that are enforced to prevent the formation of monopolies that would generally hinder competition, the merger and acquisition business has been booming, resulting in fewer public companies than a decade ago. In addition, the regulatory climate has pushed more companies into private equity rather than going the IPO route, reducing the pipeline of stocks to replace them.
According to an article in CNN Money from July of 2015, US publicly listed stocks peaked with a record 7,562 in 1998. As of the time of this article in 2015, there were only 3,812 publicly listed US stocks according to the Wilshire 5000 Total Market Index.
Increase in HFT Activity
High Frequency Trading (HFT) has increased to about half of all US trades occurring on a daily basis, adding to the effect of fewer stocks in the market. HFT strategies tend toward being market-neutral, just taking advantage of short-term pricing anomalies and not taking big bets either way. In this sense, HFTs do not contribute much net buying or selling pressure on a daily basis.
Regulatory Changes Reducing the Number of Players
Dodd-Frank legislation caused banks to disband their prop desks, getting rid of some of the most well-capitalized traders in the market. As seen when some spectacularly blew up, these traders were responsible for some significant directional bets in the market.
Fewer stocks to trade, less players to trade them, and the rise of HFT, which generally utilizes strategies which are net neutral, all serve to lessen the range of opinions in the market.
Passive Investing, where investors place their money in index mutual funds or ETFs rather than actively managed funds, has been increasing over the past decade. A recent report from Moody’s Investors Service says over 28% of assets under management are currently in passive investments, and expects that to increase to over 50% by 2024.
Passive Investing can dampen volatility as new funds are continuously deployed into the same stocks, rather than moved between sectors, or out of stocks entirely, into cash or bonds or commodities.
The new Fiduciary rules, in place since June 9, will make passive investments even more attractive, given the risk of underperformance and higher fees by actively managed funds.
More Frequent Option Expiration
Options on U.S. Stocks used to expire once a month, or even once per quarter, but now SPX, the index that tracks the S&P 500 stocks, has options that expire three times per week, with some days having AM and PM expirations on the same day. These all give investors new ways to offload risk in any time frame, lessening the need to buy and sell in the open market to adjust their positions. Moreover, investors fine-tune their bets to the point that they don’t need to overreact to market moves, which can create volatility.
New Highs and Record Lows
How do we explain the high returns we’ve been seeing, and the record low volatility, with the level of uncertainty in the air? Have we become so complacent that we just don’t react to unsettling news anymore? Perhaps investors, and the American public in general, are just getting used to the new normal. With the constant barrage of unprecedented news, we cannot turn on the TV without hearing about Russia, N. Korea, Healthcare, Climate control, and a number of globally important issues.
These types of events usually affect the market in one way or another, although the current reactions of investors are also unprecedented. Are we just desensitized to political turmoil, complacently enjoying decent returns? Some have concerns that this apparent complacency leaves investors ill-prepared for an inevitable shock to the system.
Something’s Got to Give
Historically, low volatility is good for markets, but something’s got to give sooner or later. Typically, when the VIX is high, the S&P 500 is low, which could be an appealing time to buy. When the VIX increases, the S&P 500 generally decreases. If the VIX increases too rapidly, however, investors become concerned that the market will continue to decrease and begin to react irrationally. It is this fear factor that make it difficult to trade during market volatility.
Trade with Confidence During High or Low Volatility
Experience matters, and Great Point Capital is a selected team of experienced traders. Regardless of the times at hand, an experienced trader will know how to react, or not react, to events that could rattle a new up and coming trader.
Having a stable trading platform is always important, but when volatility returns, having the right software to handle increasing quote traffic will dictate whether you can take advantage of the trading environment, or get swamped by it. Experience the sophisticated trading platform of Takion for superior performance based on your trading style. Great Point Capital is a member of FINRA.
Great Point Capital has been serving the trading community since 2001. Our 100+ prop traders actively trade the firm’s capital, specializing in equities and equity options. We are one of the very few firms able to offer access to Takion Software Platform, enhancing your trading performance. To earn to your maximum potential in times of low or high volatility, contact us today to speak with one of our knowledgeable staff.