Volatility and Its Significance

VolatilityVolatility is a measure of the variation in the price of stocks.  You may remember trading days earlier this year when the Dow Jones Industrial Average (The Dow) moved up or down as much as 200 to 300 points in one day.  That is volatility.  The VIX is a chart that was created by Chicago Board Options Exchange in 1993 to track volatility.  It is used today as a measure of the level of fear in the market.  A reading of 20 or greater on the VIX is an indication of increasing fear and readings under 20 indicate less stress in the market.  There is usually an inverse correlation between increasing volatility tracked by the VIX and a decline in prices in the market, so the index can be used as a way to monitor a potential change in market direction.  Currently the VIX is at 15.  This is well below the 20 mark; however, a change in volatility can happen quickly.  The VIX is a good risk barometer to measure investor fear and if it rises, it suggests declining prices may follow.

After a period of low volatility through most of 2014, volatility increased sharply in the 4th quarter and into the first couple of months of 2015.  In that time period the VIX closed above 20 three times as many days as it had in the previous two years.  Since March, however, volatility has settled down below 20 which may indicate that investors currently are not as concerned about an interest rate increase, the rising dollar, or troubles with Greece.

Conventional wisdom says that investors should remain invested through all the ups and downs of the market and not be concerned about volatility or a decline in market prices.  Advisors with a strategy to manage risk take a different view.  Most investors are unable to withstand a deep decline in prices, especially as they near retirement. Without a strategy to exit the market, they will stay invested until overcome by fear, selling at the bottom and missing the next upturn.   Active management is meant to keep clients out of the steep prolonged declines and keep them in the market for the smoother part of the ride.

By itself the VIX doesn’t tell us when to make buy and sell decisions, but in concert with other conditions in the market, it is a helpful barometer.   Historically, when volatility increases above 20 on the chart there is an increasing probability of a decline in prices in the market.  This would be a reason to become more defensive.  We might raise protective stops or choose to sell a stock that has been lagging the market and increase the cash position.  More cash in a portfolio builds a cushion against volatility and price declines.

The market is still struggling to stay above 18,000 on the Dow.  The Dow started the month of May at 17,840 and rose to an intraday high of 18,351 by mid- May, but closed the month at 18,010. So far in June it has fallen below 18,000 again.  The battle to break out and stay above this important line continues.  Summer is not known for being a great time for market gains, but there are always exceptions.   It is important to be vigilant or engage a trusted advisor to watch your accounts for you.

This report is a publication of Guelich Capital Management LLC, a registered investment advisor. Information presented is believed to be factual and up-to-date, but we do not guarantee its accuracy and it should not be regarded as a complete analysis of the subjects discussed. All expressions of opinion reflect the judgment of the author as of the date of publication and are subject to change.

Leave a Reply