Sunday, October 5, 2008

The Binary Volatility Regime

There is a lot of empirical evidence that suggests there exists two different states of the market: high volatility and low volatility. A corollary of this binary model is that volatility "shocks," defined as sudden large changes in volatility, are persistent; when a shock occurs that increases volatility quickly, it will stay elevated for a macroscopic (multiday) period of time. 

I agree with this model; but it is made more perceptive by adding on a level of complexity. What if there are four states to the market: high volatility & bull market; high volatility & bear market; low volatility & bull market; low volatility & bear market. This assumes that the market is either bull or bear at any point in time. Under this model, we use august 2007 as the transition from a bull to a bear market.

Right now we are in a high volatility & bear market model. This means huge moves up or down; but the market will maintain a proclivity to crash and reverse. It will be hard to make money long or short, but not impossible. Remember my previous post and buy on huge declines for a short but sure return.

The question reduces to where do we go from here? 



Charlie Ellis said...

you forgot about the fifth market model:

High Volatility & BullS***

how you like them apples? What signs are we looking for this week that holding fast in bear mode is the right course of action?

Dragonsbane said...

I disagree with your additional level of complexity. I think you will find that throughout history, bull markets tend to correspond with periods of low and decreasing volatility (thus a low and decreasing vix), whereas bear markets correspond to increased volatility. Regimes in which bull markets have high volatility or bear markets have low volatility tend to be transitory and suggest a change between actual bull and bear market is either imminent or in the process of occurring.

Just some food for thought,

RiskAffine said...


we should bounce at some point this week or else the market is REALLY in trouble


if you are using the VIX as a proxy for "volatility" then i agree with you, as high VIX readings correspond to declining prices. this is because the VIX measures the volatility implied by option prices. The spreads charged by option writers tends to expand during market stress, and thus premiums go up. Higher premiums in the absence of other changes leads to higher implied vol.

i prefer to use empirical 1 or 5 minute volatility ((high - low)/(open)) as my proxy for true vol. This way there can be high vol up markets and low vol down markets.

this makes sense: practically you have seen up markets that just fly upward and bear markets that trickle down the drain. we just happen to be in the high vol regime now.