Only the brave would guess the market’s direction, but whatever the trend, there would be losses.
Take two stocks of the same market capitalisation. Say in the same time period, stock A goes from 250 to 275 and back again to 250, while stock B moves from 250 to 255 and back again to 250. A long-term investor ignores the difference - his return from either move is zero.
Traders prefer A to B. With perfect timing, a trade may generate 20 per cent return by buying and selling A. If he uses options or futures, he could make (or lose) much more. This is why traders like volatility. Now, the bulk of market action is from traders. Their dealings reduce buy-ask spreads, generate liquidity and improve the environments for all players.
What are volatility expectations for Indian traders? Since January 1997, the average daily range of the Nifty (the most highly traded underlying) has been about 2.2 per cent calculated as the daily high-low range as a percentage of the close. It’s almost the same (2.19 per cent) since January 2009.
The frequency distribution of volatility is not a classic bell curve. It has a very long tail and a tight central cluster. Around 95 per cent of moves fall within two standard deviations ( the SD is 1.47 per cent) of the average which fits the prediction of 95.2 per cent for a bell curve. But 86 per cent fits inside one SD (3.7 per cent) from average where the bell curve prediction is 68.2 per cent.
The tail is massive. A normal distribution predicts 99.6 per cent of all values will fall within three SD of average (0-6.6 per cent). The Nifty has multiple moves beyond 5 standard deviations (9.6 per cent), and over 1.77 per cent of all sessions consist of swings larger than 6.6 per cent.
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Around 57 per cent of observations fall below the average. The median is at 1.84 per cent – half the daily moves are lower than that. The average is therefore pulled up by enormous occasional swings. Since around 95 per cent of observations conform, we can use the bell curve for rough calculations though there would be big risks in basing trading strategies on pure bell curve assumptions.
The 2.2 per cent average translates into daily swings of 115-120 points at current Nifty level. On a futures contract (market lot 50) that translates to a cash move of about Rs 6,000 crore. With leverage, it could mean daily gains or losses of 18-20 per cent for futures traders.
But the past two months have seen daily volatility drop to an average of 1.2 per cent. The past 15 sessions have seen it ease below 1 per cent, to 0.98 per cent. Since January 2010, volatility has averaged only 1.4 per cent. What does this reduction of volatility imply?
The classic interpretation of reduced volatility is that people are less fearful of big bear markets. That behavioural expectation appears confirmed by the Vix, which tracks implied volatility. The Vix is also dropping.
Since January 2010, the market has gained only 2.5 per cent. This is well below prevailing inflation. Has this eight-month period, with its real negative returns, removed all fears of renewed bearishness? That’s very, very tough to swallow.
Frankly, I cannot see a credible fundamental explanation why market volatility should have eased off markedly in the last eight months. There has been no apparent structural change that could have triggered this, in either macro-economy or market.
Lower volatility has surely reduced potential returns for traders. Obviously, those who adapted faster to low volatility made more money. Sophisticated option traders will have discovered that spreads such as butterflies and short strangles, which exploit low volatility, have become more profitable. Volumes have grown much faster in the index option segment than in futures, or any other segment, as a result.
Both traders and investors may wonder if this trend of lower volatility can be sustained over say, the next 6-12 months? Or will it end with the market reverting to the long-term, higher volatility registered over the past 13 years? Volatility is mean-reverting, according to several studies, (none of which used Indian data). As and when volatility rises, trading expectations will change.
The volatility is worth tracking, even for “fundamentalists”, since a rise in volatility is likely to presage or coincide with steep trend reversals, whether up or down. It would be a brave man who guesses the direction, however. Whatever the direction, there would be huge losses incurred at the transition point when volatility spiked.