Originally published by AxiTrader
One of the things I often write and say when I am talking to traders and with my mentees is that volatility clusters.
That's important in the current environment where realised and actual volatility had been so low for so long before the big moves in forex, gold, bonds, and in US stock markets. The overnight ve in stocks - which saw the Dow Jones Industrial Average and S&P 500 lose around 1.8% while the Nasdaq 100 lost around 2.5% saw the CBOE Volatility Index spike 46% - admittedly from ridiculously low levels - to 15.59.
That's a little higher than the average weekly level the VIX has traded at over the past 3 years but much below some of the spikes we have seen over this period. Indeed getting volatility back to average levels is really only just a starting point.
That's particularly the case if traders and investors really start to worry about the weak US data flow and the real chance that the delivery and implementation of the Trump administration's tax and spending plan could be indefinitely delayed.
Never mind that the Trump presidency and the project it represented to reinvigorate US business and the market could be critically injured.
I've written on the outlook for US stocks and in particular the S&P.
Benoit Mandelbrot
But what I want to focus on in this piece is the lesson I learned from Benoit Mandelbrot.
He's the father of fractal geometry and challenger of the market orthodoxy that said price moves follow a random walk. His book, along with Richard l. Hudson, The (Mis)Behaviour of Markets - a fractal view of financial turbulence, is a must read for anyone who is serious about trying to understand markets.
Anyway, as I wrote in the introduction Mandelbrot says that volatility clusters. And that, in turn, tells us that last night's stock market move is unlikely to be a one-off.
"Large price changes tend to be followed by more large changes, positive or negative. Small changes tend to be followed by small changes. Volaitility clusters," Mandelbrot and Hudson wrote.
Bloomberg columnist Matt Levine explained why volatility has been so low recently in his column Worries, volatility and activism.
"The reason that volatility is low is that dealers are suppressing it. The reason dealers are suppressing realized volatility is that they are long a lot of options and need to hedge.. The reason they are long a lot of options is that investors have sold them a lot of options. (The reason they need to hedge is that they are not in the business of taking outright positions: They are service providers, bookies, not bettors themselves.)" Levine wrote.
He added that there is a self fulfilling nature of volatility - one that I think help's explain why Mandelbrot is right and volatility does indeed cluster. "the reason that investors have sold them a lot of options is, roughly speaking, that investors think volatility will be low. Combining all that, you get: The reason that volatility is low is that investors think volatility will be low."
"The reason that investors have sold them a lot of options is, roughly speaking, that investors think volatility will be low. Combining all that, you get: The reason that volatility is low is that investors think volatility will be low," Levine wrote
In other words, volatility clusters because traders and investors either become complacent and sell vol or, having over egged their expectation of calm days ahead, need to scramble making the reverse also true as volatility clusters on the high side.
The behavioural finance and economic guy in me also like how he explained what financial markets really are about. into the mix Levine also says, "The reason that anything is anything, in financial markets, is that people think the thing will be the thing. That's what financial markets are; they're mechanisms for transforming investor opinion into asset prices".
Levine wrote, "the reason that anything is anything, in financial markets, is that people think the thing will be the thing. That's what financial markets are; they're mechanisms for transforming investor opinion into asset prices".
Back to Mandelbrot.
Now, it's worth stating that Mandelbrot also says last night's fall in stocks, or the US dollar, the rally in gold, and moves in other assets aren't necessarily indicative that the next day's move will be in the same direction.
Rather he says, "a 10 percent fall yesterday may well increase the odds of another 10 percent move today - but provide no advance way of telling whether it will be up or down".
That's more than a little unhelpful for prognosticators and even Mandelbrot asks "what use is that".
And it's his explanation of what traders with a low risk-tolerance should do which neatly explains why volatility transitions.
His answer is that "a fund manager or investor who can not tolerate the risk of a large loss might, when the financial storm signs are up, simply trims his sails and avoid bold bets".
That's exactly the reason why the Aussie dollar usually does poorly at times of increased uncertainty and high stress in markets. Investors focus on their core markets and cut back non-core positions like the Aussie dollar.
And that's the key to where stocks might head next and why we could end up with a series of days with increased volatility and wild price swings.
After fully assimilating Trumponomics and Trumpflation, and in driving stock market volatility to the lowest levels since 1993 traders must now unwind these bets as the tumult in Washington makes them rethink their assumptions.
There is plenty of sail triming to be done until order is restored and clarity return.
Volatility clusters folks. Volatility clusters.
Have a great day's trading.