You’re probably wondering what the image above is, right?

You’ve sussed out that it’s got something to do with volatility but it’s not like the indicators on your chart, and it sure as hell isn’t the VIX !

You’re about to find out, but first let’s talk about why it matters . . .

Volatility is on the Increase

Pretty much every trader knows that markets have become more volatile over the past six months, and most market professionals and analysts expect this trend to continue into 2015.

If your own experience (or the balance of your brokerage account) isn’t enough to convince you of this, then you need only take a quick look at this chart of the Volatility Index to grasp what’s going on:

One strategy that I run that is particularly long term in nature is predicated almost entirely on reducing volatility. That means that it isn’t especially seeking returns over and above any benchmark, it’s just looking for an average performance but with reduced volatility. Even this has had a rough six months!

In equity markets volatility is generally associated with declining prices, as becomes obvious during corrections where a few days of high volatility can erase months of gains. To demonstrate this point, take a look at the next chart. It shows ETFs tracking both Total US Stocks ($VTI) and the CBOE Volatility Index ($VXZ), along with their thirty day correlation.

The VIX is often referred to as the fear index, and is a measure of the market’s expectation of stock market volatility over the next 30 day period.

The two are almost always strongly negatively correlated. That means that when volatility is increasing, stock prices are generally falling. Please be note that as Michael Harris has argued in ‘On the Zero Predictive Capacity of the VIX‘, this does not necessarily mean that the Fear Index provides any leading indication of future volatility or returns.

The Volatility-Split Chart

This brings us rather neatly back to the image at the top of this page. What is this chart? Here it is again:

What you’re seeing is price volatility split into two types: ‘upside volatility’ and ‘downside volatility’. The green histogram tracks volatility to the upside, and the blue histogram tracks volatility to the downside.

And regardless of what you might have been expecting, prices don’t obviously exhibit more volatility to the downside.

In other words, although prices might generally be falling when volatility is rising, as part of this process there is just as much movement to the upside. What is lacking is the ability to sustain this movement. If you’re a daytrader this is invaluable information: even though the overall direction might be down, volatility still brings plenty of opportunity in moves to the upside.

Taking it Further

One interesting angle to explore might be whether some sort of arbitrage opportunity exists when upside volatility is rising but the VIX is falling.

Another question is whether this is true for other types of markets such as forex, where there is no long-term expectation of rising prices brought to the market by investors. It is easy to imagine that volatility in a currency would be equally distributed to both the upside and the downside.

Larry Connors discusses an effective strategy in his book ‘Short Term Strategies That Work‘, which involves going long whenever the VIX rises above 13, although if Harris’s article is taken as granted then this may be little different to buying whenever price falls below a certain level.

You might also like to take a look at our articles about Weathering the Volatility Storm.

In any case, you’re hopefully now a whole lot wiser about the true nature of volatility and how it relates to market returns.

View similar articles about investing in stocks: Stocks Knowledge Base