What Volatility Tells Us About What’s Next

Quant traders, I can’t help myself.  I’ve got another “since” data point. 

I’ve said before that I mock the folks saying, “It’s the longest stretch since…” So yes, I’m mocking myself here too.

But.

We’ve had the longest period SINCE (there it is) we’ve been tracking data for EDGE back to July 2017 with volatility below 1.5% in big ETFs tracking the S&P 500 (you know what they are).  You have to go back to May 27 for the last time volatility in them rose over 1.5%, and it was 2.2% that day.

It suggests probability of a volatility spike of at least 1.5% is coming, merely because it hasn’t.  The volatility bottom has crept up since Sep 17 (the lows are higher). 

Why does it matter?  Because we trade volatility.  Remember the EDGE 1-2-3 rule?  S&P 500 ETF trackers have a propensity to move about 1% daily between high and low prices.  The 200-day average in those instruments is 1.2%.  And since July 2020 – more than five years – it’s averaged 1.2%.  That’s the “one” in the formula.

Stocks comprising the basket the ETFs track averages about 2% volatility.  The 200-day average is 2.5% but every shorter read is about 2.2%. 

Volatility has diminished in the trackers but not proportionally in the basket of stocks comprising the S&P 500. See what I mean?  Volatility is down about 12% in S&P 500 stocks over the shorter run vs the 200-day average but down 42% in tracking ETFs.

Now, how can that be?

Well, clearly the ETFs don’t hold all 500 stocks all the time!  They use a gentler statistical sample (read the prospectuses and you’ll see that most ETFs do that). 

Which brings us to the “three” in the 1-2-3 rule.  Momentum stocks have a tendency to move 3% or more.  There’s excess Demand for them, so price moves disproportionately.  That’s why we look for Demand/Supply divergences. That condition creates a higher probability of positive price-movement in the form of volatility – which we take.

Like ASTS yesterday from the EDGE Momentum Daily Trading Ideas portfolio, which was in the entry range early in the day and then rose 9.2% — the full average five-day volatility for ASTS.

It’s why our target in Daily Trading Ideas is 2%.  You’re likely to get it routinely (for more, try EDGE).

Here’s where it gets interesting. The majority of market cap is Tech, if you add together the sector, Communications Services stocks, and Consumer Discretionary stocks that are technology plays, like Tesla, Booking.com, DoorDash, Amazon, Alibaba, Pinduoduo, Sea Ltd.

And volatility in the Tech sector is 2.8%.  How can tracking ETFs have volatility of 0.7% if the underlying stocks have much higher volatility?  So-called “market makers” like Jane Street that keep stocks and ETFs aligned are absorbing spreads. Which is BIG money – the difference between 2.2% and 0.7%. 

You and I cannot afford the data feeds and computing systems necessary to keep up in real-time with the spreads and capture them.  And “market-making” distorts returns. It makes ETFs much more stable vehicles than the market really offers. 

Until that breaks down.

The term “market-making” implies altruism but these firms are trying to make money by finding spreads the same way we do. The difference is their timeframes are shorter, the target spread is smaller. 

Can we win then?  Well, sure! The short-term pursuit of those gaps by machines manifests in Demand and Supply, permitting us to profit on Daily Trading Ideas and the EDGE Model Portfolio.  

The key is to stay on top of trends.  When the trends in Demand and Supply change, beware.  And one just did.  For the first time in a dozen trading days (there I go again), Supply marketwide – Short Volume – stopped falling. It could be a tell, a signal of coming volatility.

PS – For more, join the free live Demo Thursday Oct 9, 2:30p ET.