Volatility Is Dangerous for the Markets
NEW YORK ( TheStreet) -- I spoke at a conference recently, presenting my ideas about generating alpha.
As I spoke, some folks were nodding their heads in agreement, some were doing their BlackBerry prayer and some were simply not present. Typically that's how it would end: some exchange of ideas, a nice conversation, but no more.
But I had more to say. I started talking about volatility and how it affects the generation of alpha. The effect, unintentionally, was amazing: The heads went up, the BlackBerrys went down and the room became focused. It was as if everyone had been given an intravenous injection of 5-hour Energy.
So what is it about volatility? The standard textbook definition I teach to my finance students when I am not managing client portfolios is that volatility (or standard deviation) is the square root of variance, which is the sum of squared deviations of stock returns from its mean.
Now if that is not a mouthful, I don't know what is. It is certainly not this definition that makes people pay attention. A more common definition of volatility is the riskiness of a security.
There is something about volatility that simply gets everyone's attention. Although I wish I could take credit for the reaction I got at the conference, it was the mention of volatility that generated the excitement. Volatility typically brings out gut reaction and gets everyone excited. It is like a roller-coaster, exciting and scary and the same time.
The higher the volatility, the stronger our reaction up and down.
It is well documented that current volatility is considered low. The chart below shows the level of the S&P 500 index on the left scale and the rolling 12 months of volatility on the right scale.
The reason everyone perked up when I started speaking about volatility is I raised an issue everyone has buried under the carpet as of late. No one, whether in the audience or my company's clients, believes volatility should be this low, but we don't talk about it.
There are many things that are driving this view. The economy is sluggish and the main barrier to growth is unemployment, which is stubbornly high. We have the "fiscal cliff" situation that, if not resolved, can potentially slow the recovery. The European recession is in full swing and there is some risk of a breakdown of the European monetary union. The on-again, off-again crisis in the Middle East in Syria and, more significantly, the confrontation with Iran can drive even more uncertainty in the world markets.
In addition, the implied volatility is low as well. The implied volatility has many explanations: There is the fundamental financial definition that says it is based on today's option price of the S&P 500 index, from which the future (or implied) volatility can be derived using the Black Scholes option pricing model.