Theory on Market Volatility

I recently read a tweet that stated that the S&P 500 has not had a 3% weekly move, up or down, in 87 weeks.  I can probably remember the last time it happened, it was the first week of January 2013, when we had a huge ramp up from resolving the much worried about fiscal cliff.

It got me to thinking about the reasons why the market volatility remains so low.  I can think of it in terms of trading a long time ago, in stocks, when I was short selling active daytrader stocks.

For those that are familiar with short selling daytrader stocks, a bull market provides much much more opportunity to make money than a bear market.  It is counterintuitive, because many more stocks go down in a bear market than in a bull market.  But most of the best stocks to short have no relevance with the real economy, or even the S&P 500, because they are either scams or have no viable long term business.  In order for there to be a good short selling opportunity, a stock has to go up above and beyond its reasonable value.  That happens much more frequently in a bull market than in a bear market.

One of the reasons short selling was so profitable during the dotcom boom (before the bust), was because there were so many stocks where the price was going way beyond their fair value.  People usually assume that those that made money in the internet bubble did it by going long the internet stocks.  While among the small minority, I know many traders that made their money exclusively shorting pumped up POS during that era, trading short term, with most trades lasting just a few days.

During those internet boom years, the number of traders playing the long side overwhelmed the number of traders playing the short side.  There are always more traders willing to go long than short individual stocks, even in a bear market. That's just how the market is.  The long/short ratio in short term trading was even more highly skewed than normal towards longs during that time period.  What you had was a lack of shorts in speculative stocks, which allowed a pumper that ran up on some news release, to go from 8 to 18, instead of just going from 8 to 15, because of all longs overwhelming the natural sellers, and also the lack of short sellers.  And after the pump was over, because of the lack of shorts covering during the subsequent dump, the stock would actually fall further on the way down, going from 18 to 11, for example, instead of say 15 to 12.  If you had a more normal ratio of shorts to longs, the volatility would have been dampened.

Of course, high volatility is a double edged sword.  If you are too early in entering a position when volatility is high, there is a lot of pain to be endured, even possible margin calls, before the position goes your way.

There is a certain range for the ratio of willing buyers to sellers that needs to be maintained to have low volatility conditions.  Granted, this range is usually maintained in equities, so markets are usually low in volatility.  But when you get a ratio of willing buyers to sellers that is skewed towards too many buyers, you get volatility at the top.  If you get a ratio of willing buyers to sellers that is skewed towards too many sellers, you get volatility at the bottom.  Emphasis on willing, because buyers and sellers always have to be matched.  In order to entice unwilling buyers to buy at the bottom, you have to lower the price.  And vice versa at the top.

Bottom line is that this kind of low market volatility condition is not a symptom of a top, but a symptom of a balanced ratio of willing buyers to sellers.  You don't often see a market top under these conditions.  Remember in the run up from 1991 to 2000 bull run, the lowest VIX years were not when the market was near their highs in the bull run, but in the middle of it, in 1993 and 1995.  And in the bull run from 2003 to 2007, the lowest VIX years were in 2005 and 2006.