They always say that when the good times are rolling, you should roll right along.
Schalk Louw, PSG Wealth Old Oak Principal says however that sometimes it’s actually better to listen to the cautious voice in your head than follow the rest of the herd.
Investors tend to think that, overall, low volatility is ‘good’ and that high volatility is bad.
“In reality, in times of high volatility, emotion plays such a huge role in investors’ decisions that they actually force the market to lower levels than its fair value indicates. In times of low volatility, investors are convinced that the market cannot fall to lower levels, forcing it upwards as has been happening over the past 12 months,” Louw says.
As an indicator, volatility can be used not only to determine risk, but also to identify possible investment opportunities and danger zones. It is not, however, a directional indicator.
An excellent tool to use when gauging volatility is the volatility ratio (VR), a measure through which the price changes of an asset, whether up or down, are expressed as a percentage.
If share A’s price rises from 100c to 101c, for example this would indicate a positive change of 1%. If share B’s price falls from 200c to 198c, it would indicate a negative change of 1%. The VR (of 1%) of both these shares is the same, which means that the VR of share A is equal to the VR of share B.
If a particular share has a VR of 20, it means that its price has moved up and down by 20% over a particular period. “As a result, by buying this share, you don’t only stand the chance of 20% growth on your investment, you also risk losing 20% of its value,” says Louw.
In the US, when trying to predict which way the market will go, investors look at what is colloquially referred to as the fear index or the fear gauge. This is the VIX, a popular measure of the implied volatility of S&P 500 index options. It is calculated and published by the Chicago Board Options Exchange (CBOE).
Each time that the volatility index (VIX) of the Chicago Board Options Exchange (CBOE) moved to levels above 45, the US market was always regarded as completely “oversold” and correspondingly, was seen as the greatest buying opportunity in the market ever. It remained that way until it moved back down to the perceived “saturated” levels of around 10, which indicated a possible turning point in the market to investors.
The last time that our market reached a VR of around 10, was shortly before the great correction of 2008 and we all know how that ended: with a near 50% decline in US$ terms.
Recently the S&P500 Index made history. For 105 consecutive trading days, for the first time since 1995, the Index did not see a decline of 1% or more.
At the same time it has brought the VIX back to the same levels as in 2008. It just so happens that the last time that the SA Volatility Index (SAVI) traded at levels similar to the VIX’s current levels, was in June 2014. The result since then: almost no growth for nearly 3 years.
Louw stresses that the VR shouldn’t be used as a directional indicator. Rather use it to determine risk or an overreaction in the market.
“It doesn’t matter how you use the stock market as an investment vehicle, as long as you do your homework properly and more importantly, make sure that by following the herd, you don’t end up biting off more than you can chew,” Louw concludes.