How Volatile has the Stock Market been?

 

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After recovering from the March 2020 lows, the major indices (Dow, Nasdaq, and S&P) have been on a tear, reclaiming the earlier highs. 

On its way to retesting the old highs, the market did dip several times, offering better buying opportunities, especially in late May and mid-September. For example, after reaching 27,000 in late May, Dow quickly fell back to 25,000 and provided a similar opportunity again in late September.

Though the growth has not been a perfectly linear, the investors nonetheless fared very well who stayed on or bought the dips.

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The High-to-Low ratio is one of the quickest ways to understand market volatility. Obviously, the bigger the spread, the higher the volatility. In a stable market, this ratio will be range-bound between 101 and 103. When it spikes above 105, the market enters a phase of turbulence.

The above graph confirms that the market experienced a very high level of volatility in late May and early June; for example, from a low of 102.74 on 5/18, it dramatically climbed to 109.98 on 6/8, steadily retracing back to 103.03 on 7/56. 

Many quantitative funds and traders take advantage of this volatility via liquid derivatives like options on Indices, VIX, etc.  

Stay safe!

-Sid Som

homequant@gmail.com

Understanding the Market Volatility ... 12/2/2019 thru 3/2/2020

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Paula, a Research Analyst with a Master's in Public Health, is interviewing for a Senior Health Care Analyst position. Here is the simulation of the first interview, leading to the final interview.

Interviewer: Paula, since this is a general interview to narrow our choices down to the final ten, it is designed to test candidate's knowledge of the basis data analysis and modeling, rather than the health care data universe per se.

Paula: Sounds very reasonable.   

Question # 1
Interviewer: Lately, the stock market has been going through some serious turbulence so we decided to use the current market data as the basis for this general interview. Does the High/Low Ratio ("Hi/Low") proxy the VIX in this example?

Paula: Yes, it does. A high correlation coefficient of 0.88 confirms that they have been more or less moving in tandem. For example, when the Hi/Low jumped from 101.79% to 115.08%, the VIX also jumped from 17.08 to 40.11. They have a high positive correlation, meaning they move in the same direction.

Question # 2
Interviewer: So, are these two volatility metrics -- Hi/Low ratio and VIX -- interchangeable? If so, is there any need for the Hi/Low ratio? 

Paula: The two metrics are not inter-changeable. The Hi/Low ratio is a descriptive metric that helps analyze the past activity but does not project anything about the future sentiments of the market, whereas the VIX is computed in a more forward-looking manner to project out the short-term future sentiments of the market so they, in a way, complement each other.

Question # 3
Interviewer: In this example, 10 out of the 14 weeks, VIX remained within a tight range of 12.10 to 15.47. How come the average is 18.04?

Paula: Average is heavily influenced by the outliers. The two outlier data points of 40.11 and 41.94 are weighing in, pulling the average up. If you had used the median, it would be around 14, not 18.

Interviewer: Let me quickly check what the median would be. Yes, it's 13.85. Great mental math!

Question # 4
Interviewer: Using your logic of median, if we re-compute all components, what changes would we expect to see?

Paula: The impact of the two lower outlier data points of High, Low and Close would be minimized, thus pushing their median values up. On the contrary, the impact of the two unusually high outlier data points of Volume and Hi/Low would be significantly lessened, thus pushing their median values down.

Question # 5
Interviewer: Is there any other market component that demonstrates a similar relationship with the VIX?

Paula: Yes, the Volume component. In fact, VIX and Volume show even a higher correlation of 0.90. Case in point: When the Volume spiked from 1.096B to 3.019B, VIX jumped from 17.08 to 40.11, proving how they move almost in lockstep.

Question # 6
Interviewer: In terms of Volume, does anything else stand out?

Paula: Yes, the two traditionally-low Volume weeks of 12/23 and 12/30. If you compare the Volume of 12/23 with that of 2/24, you see a huge change -- in fact, a factor of 4.5. Of course, it's an aberration, not a norm.

Question # 7
Interviewer: Why did it happen?

Paula: It's strictly news-driven. The news pertaining to the outbreak of Coronavirus has been making the financial markets around the world very nervous. The uncertainty surrounding this outbreak has a prolonged impact. The financial community needs to have more clarity about this breakout before a real sense of calm returns to the market.    

Question # 8
Interviewer: You seem to think that the many unanswered questions about this outbreak are impacting the market. Please name one such unanswered question that is plaguing the healthcare industry. 

Paula: We do not know who will pay for the tests and possible hospitalizations for the millions that are uninsured. Even the millions that are insured with high deductibles are very nervous. For instance, my mom is self-employed so she pays for her own insurance, but to keep the premium manageable, she opted for a plan with a high deductible which is making her very nervous now.

Question # 9
Interviewer: Why do you think the Low and the Closing prices ("Close") have near-perfect positive correlation?

Paula: When the market has been trending down, Low and Close go more or less hand in hand. The flip-side is equally true -- simple collinearity!

Interviewer: Congrats, Paula! You have moved on to the final round. Any questions?

Paula: Thank you very much. If I get this job, do I get to report to you directly? Actually, I would love to be on your team.

Interviewer: I would love to have you on my team, too!

- Sid Som, MBA, MIM
sidsom1@gmail.com

The Final Interview

Link to the Book

How did Dow Jones Industrial Average (DJIA) Fare in 2019?

** Intended for New Graduates **

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Jason is interviewing for Senior Research Analyst with a major brokerage house.

Interviewer
Question # 1: How would you interpret the 2019 DJIA trend?

Jason: Visually, it's a linear trend. It has been trending at 45 degree. 

Interviewer
Question # 2: When you say 'Visually,' do you mean there could be a better technical trend?

Jason: Yes, a polynomial trend would show better fit with significantly higher r-squared. Yet, I would stick to the linear trend as it would be easier to explain to the general clientele.  

Interviewer
Question # 3: What is the missing piece between these two graphs? Or, is there one?

Jason: Volatility. While the Weekly one depicts the market volatility, the Monthly one irons it out. 

Interviewer
Question # 4: Is there another way to depict the market volatility? If so, would that make the volatility case any stronger?

Jason: The Daily closing graph will show higher volatility but it won't make a better case than the Weekly one. As you know, a level of smoothing -- which the Weekly one incorporates -- is a better way to present volatility to the general clientele. 

Interviewer
Question # 5: What market event is common in these two graphs?

Jason: The precipitous market drop in May, bringing Dow under 25,000. Of course, by early July, Dow climbed to a new high, crossing the 27,000 mark. 

Interviewer
Question # 6: Do you think the May correction was driven by basic fundamentals of the market?

Jason: No. It was more news driven like trade, tariffs, etc. than pure market fundamentals. 

Interviewer
Question # 7: How did you come to the conclusion that it was news-driven rather than fundamentals-driven?

Jason: Had it been fundamentals driven, the correction would have lasted much longer. Instead, you can see the immediate V-shaped recovery leading to new market highs.

Interviewer
Question # 8: What is the difference between the 2-period and 3-period moving averages in the above graphs?

Jason: The 3-period in the Weekly graph points to 3-week moving average, whereas the 2-period in the Monthly refers to 2-month moving average.

Interviewer
Question # 9: Would you advise your clients to continue to pour in money in Dow in Q1-2020? 

Jason: Selectively. I will continue to recommend the Dow components with high dividend payouts. I will also urge them to keep some cash handy, just in case a correction occurs, leading to good buying opportunities.

-Sid Som, MBA, MIM
President, Homequant, Inc.
Homequant@Gmail.com

Link to the Book