Chart of the Week – March 6, 2004
Brett N. Steenbarger, Ph.D.
Traders commonly rely on the VIX to assess market volatility. While that is helpful in gauging day-to-day and longer-term shifts in volatility, I find it less helpful for intraday trading. Accordingly, I have developed a measure of short-term volatility that appears to have some promise as a trading tool. It is not so much a timing measure as an indication of whether you can expect increasing or decreasing market movement in any contemplated trade. This information can be very helpful in setting stops and in allocating capital to trades. The same setup in a highly volatile market and a highly non-volatile one would likely carry different profit targets as well.
What makes the Short Term Volatility Index unique is that it is not price based. It is constructed by measuring the amount of buying and selling occurring at highly frequent intervals during the day and computing the absolute value of these numbers. To smooth out the noise in the very frequent readings, I aggregate the data on a five-minute basis and plot the Index as a one-day moving average.
Below is a short-term chart of the Volatility Index covering the period from March 1, 2004 to March 5, 2004. Notice that the Index, in blue, tends to move from levels below 400 to levels above 550. Extreme readings of 350 on the low side and 600 on the high side do occur, though not frequently. The most common pattern is that we see market tops occurring at periods of low volatility, when markets top out, and market bottoms at periods of high volatility during panic selling. This can be observed in the first half of the chart, if you focus on the data at the left hand side of the display.
We can have the situation, however, where volatility will be lowest at a market bottom, after a period of bottoming, and then spike higher as the market makes a high momentum move upward. This tends to occur in strong bullish markets, and can be seen on the right hand side of the chart during the action of Friday, March 5th.
Because of the different dynamics of price rises and declines illustrated by the two halves of the chart, it is a mistake to trade the Volatility Index as a timing tool to identify tops and bottoms. Rather, it should be viewed as a tool to identify promising breakout moves. When a market breaks to a new high or new low during a period of rising volatility, the move will have more “energy” behind it for continuation than if the move occurs with waning volatility. Because of the regular cycling of volatility from low to high levels and back again, breakout moves during periods of low but rising volatility may be particularly promising—as we saw in Friday’s market.
Below is a second chart of the Short-Term Volatility Index, this time covering the longer period from January 2, 2004 to March 5, 2004.
The cycling of the Index between the 400 and 550 regions can be clearly seen in the blue line. Also evident is the common pattern in which we see high volatility at short-term market bottoms. One plausible timing tool could combine a measure of market trend with the Volatility Index to determine profitable points for buying the market after declines. In the middle of the chart, late in February, we had very high volatility and very negative Power Measure readings. This indicates panic selling and often sets up a tradable bottom. Conversely, on Friday, March 5th, we had positive Power Measure readings and a low Volatility Index. This set up a sharp upmove within the bullish short-term trend.
The interplay of price and volatility determines the direction of short-term trends and the vigor with which they will move in that direction. By limiting trades to situations where there is a high probability of a directional move with superior vigor, we can improve our % winners, but also the average size of those winners.
Brett N. Steenbarger, Ph.D. is Associate Professor of Psychiatry and Behavioral Sciences at SUNY Upstate Medical University in Syracuse, NY. He is also an active trader and writes occasional feature articles on market psychology for MSN’s Money site (). The author of The Psychology of Trading (Wiley; January, 2003), Dr. Steenbarger has published over 50 peer-reviewed articles and book chapters on short-term approaches to behavioral change. His new, co-edited book The Art and Science of Brief Therapy (American Psychiatric Press) is due for publication during the first half of 2004. Many of Dr. Steenbarger’s articles and trading strategies are archived on his website, .