Is it possible to predict the volatility of the stock market? In this article, we will look at some methods used to predict market volatility.
Some stock markets are more volatile than others; many factors influence volatility. You can learn more about this topic in this article: What increases market volatility?.
Being able to forecast market volatility accurately allows us to adjust our exposure and limit risks.
In fact, the higher the expected volatility, the lower our monetary exposure in the equity market should be.
The most important thing to remember is that volatility is cyclical. Moments of low volatility always alternate with moments of high volatility. In more mature markets like the S&P500, volatility tends to be quiet most of the time.
Other stock indices such as the Russell2000 or the Nasdaq are more volatile. The commodities market is much more volatile than the stock market.
Some news can increases volatility, but, in most cases, the market finds balance in a short time.
In the equity markets, volatility increases during falls, while it tends to fall when prices rise. Using a simple atr on the S & P500 index, you can clearly see how volatility correlates with the market’s direction.
This phenomenon is effectively represented by the VIX, the so-called index of fear.
As we will see below, it is challenging to predict volatility through technical analysis. We can check past and present volatility with technical indicators, but we will hardly have a future forecast or expectation.
Analyzing the option pricing, it is possible to predict volatility. In reality, it is not an accurate prediction; it is an expectation. Option pricing is influenced by analysts ‘and market participants’ expectations of future share prices.
Predicting with technical analysis
It is almost impossible to predict the volatility of a stock market through technical analysis. The classic volatility indicators present in the platforms analyze past data and highlight the current trend.
The Average True Range is the most famous volatility indicator and can indicate where we are now.
Using an Average True Range with a moving average, we can take advantage of the cyclicality. However, it is a rough analysis.
The ATR is very useful for calculating the position size. When the ATR is above its 20-period moving average, we can reduce the market exposure and vice versa.
Price action can be used as a forecasting tool. Volatility can increase when the price is chopping for a long time and then breaks to the downside. However, even this analysis is not accurate and reliable enough.
Another indicator that is often used is the Bollinger Bands. Unfortunately, a sudden expansion of the bands or a contraction does not tell us anything about the future.
It is possible to use technical analysis on a volatility index to have reasonably accurate indications. In this case, however, the technical analysis is made on expectations and not on past prices.
Using option pricing to predict future volatility
It is the best tool for predicting future volatility. Many investors use the options market as a hedge.
To anticipate a downside on the S&P500 stock index, we can buy put options and hedge against the risk.
When markets rise, put options fall in value; buying them at certain times is like taking out an insurance policy.
If the stock market falls, volatility will increase accordingly, and the price of put options will inflate. The gain from the purchase of the put options will cover the accumulated losses in the stock market. We are also managing to predict the correct timing of the sale of options contracts.
When many investors buy put options, their price will tend to rise like any other financial instrument. This rise in prices is used to predict a market decline and, consequently, increase volatility.
THEREFORE, as I wrote previously, it is not an accurate forecast but an expectation of most large investors.
S&P500 volatility and VIX
The index is named the fear index because it rises as the fear of a stock crash increases. When investors buying put options, the index rises, and vice versa, it decreases when more call options are purchased.
Sometimes the VIX index goes up while the stock market is a critical wake-up call. The VIX index moves downward reasonably quickly and can go up by many percentage points in a short time. Then slowly begins to descend again; the time it takes on the descent is infinitely longer than on the ascent.
Using technical analysis on this index, it is possible to obtain excellent signals. The simple crossing of two moving averages calculated on the VIX indicates the rise or fall of volatility.
This tool is helpful if implemented in an automatic trading system. Otherwise, the simple observation of the VIX chart gives us all the necessary information.
Using an automatic trading system, we can use the VIX as a filter to stops the trading strategy. For example, we stop trading when the VIX’s five-period moving average is above the 20-period moving average. A simple setup that can save you a lot of money.
There are also other volatility indices. We have an index for the Nasdaq, for the Russell, and even for individual stocks.
These tools are reasonably accurate, although ultimately, moving quickly won’t give you time to enter the market. By the time the VIX starts moving, the market has already fallen.
As I said, an important signal could be an upward movement of the VIX during a bull market. Some investors are likely hedging from an event that not everyone has foreseen yet.