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Low Volatility

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Late last October, I read an article that made a prediction of where the SPX might be in sixty days. I'm a bit of a doubting Thomasina so I sat the article aside to test the conclusions I read there. I found the article recently and looked to see if the conclusions had proven sound.

The article's author claimed that market pundits who were then pointing to the low volatility levels and screaming that the sky was falling just weren't paying attention to historical norms. When volatility dipped, the SPX was likely to be higher by about 3.37 percent, on average, sixty days later, Brett N. Steenbarger, Ph.D. claimed in an article written for www.tradingmarkets.com on October 23, 2006.

Was he right?

Annotated Daily Chart of the SPX:

Steenbarger was right. He wasn't using the VIX as a measure of volatility but rather was looking at the average high-low range over a given period of time. When he wrote the article, the SPX's average daily trading range had dipped below 1 percent for the number of sessions he considered on intermediate-term and long-term periods: 40, 200, and 500 sessions. That was a relatively rare occurrence, he pointed out, happening just over 13 percent of the days stretching all the way back to 1964, when he began collecting his data. He found those 13 percent of days to have clustered in three periods. The latest of those periods stretched from May, 2005 up through the time of his article.

What's more remarkable is that he wrote that article while others were pointing to too much complacency in the market and a likely downturn immediately ahead. That's why I wasn't ready to trust his conclusions without testing them by watching what happened over the next 60 days.

Steenbarger countered those clamoring that there was too much complacency in the markets with the contention that no declines of 10 percent or more had occurred within 60 days of the type of low volatility he was measuring. Although some 5-6 percent corrections had occurred during that period, no true bear market had begun. Moreover, he argued, low volatility can continue longer than most market watchers insist it can.

The article, and the 60-day period have long since passed, and Steenbarger has proven right. What good does that information do us now?

First, it tells us to question the assumptions that we're routinely handed. Steenbarger was right, not the others. I wasn't among those clamoring about too much complacency since my own search of historical norms had shown me that my preferred measures of volatility, the VIX and VXO, can and do stay low for much longer than anyone would expect. However, that low volatility was certainly a concern for me, because I worried about what would happen to bullish plays if it suddenly exploded higher. I wasn't ready to immediately trust Steenbarger's contention that the SPX was likely to be higher at the end of the next 60-day period.

This tells us to do our own research, especially when we're deciding who or what information we can trust. That's the reason I set that article aside, to test Steenbarger's conclusions when that 60-day period had ended.

So, perhaps Steenbarger's research has something of worth for those of us always looking for a deeper understanding of the markets. His mathematics-based study of the markets and market psychology appeals to me, at least. My test of his theories gave me enough information to decide that I would at least listen to what he has to say.

So, what is he saying about the markets recently? A second test of his conclusions might be in order. As this article was roughed out on Sunday, May 06, Steenbarger's blog featured a chart that reminded me in some ways of the great charts that Keene Little has been posting in this Wednesday-night Wraps. Steenbarger was measuring breadth against SPY performance, with Steenbarger's preferred breadth measurement the ten-day new highs minus lows. He was noting, as OIN's Keene Little has been with the SPX and his preferred breadth measurements, that SPY prices are outstripping that ten-day new highs minus lows.

Up until that time, Steenbarger wasn't seeing signs of serious topping but he professed that he wouldn't be surprised to see the SPY drop below 148 support, beginning the topping process. He thought that unless the SPY could move above the prior day's high, he was inclined toward the short side.

Steenbarger's inclination didn't prove to be totally fulfilled that next week although some elements were. The SPY didn't drop to 148. Instead, it did push past the previous day's high on May 7, the next trading day, and it was off to the races, as it has been with other securities. Presumably, because that "unless" clause was fulfilled instead, Steenbarger wasn't immediately inclined to the short side the beginning of that next week.

The week ended down, just as Steenbarger had predicted, although it certainly took a wild ride to the upside first and the SPY never reached 148. By the time the SPY did dip, the support had presumably risen.

I don't fault Steenbarger for not being totally correct. The attempt to move higher was quickly and harshly rebuffed on May 9 and the week did end lower, and we all know, as does Steenbarger, that momentum can carry a move further than we expect.

No matter how valid you consider Steenbarger's May 6 conclusions to have been, he offers many articles and tips that can be useful for all traders. I encountered intraday blogs on volume patterns in the ES, what the closing values of the VIX predicted about the next few days' trading ranges, and when traders were most likely to violate their trading plans. Now that you have enough information to make up your own mind whether Steenbarger's conclusions have any validity, you can decide whether you want to study some of that information, such as how intraday ES volume patterns can be used to tailor trading strategies. You can find Steenbarger's blog on a mathematical take on trading psychology and breadth information at http://traderfeed.blogspot.com/

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