Stock market volatility refers to the daily variation of stock prices. For years we at Huygens have been using and improving our stock market volatility prediction systems to drive our active investment portfolios.
Our active portfolios are designed to capture gains in periods of low and declining volatility, and to rotate to defensive/bearish positioning when our systems predict that stock market volatility is increasing or abnormally high.
Why predict stock market volatility?
Higher volatility is strongly linked to higher likelihood of investment losses
Consider the following analysis, which breaks the timeframe 1992 through 2018 into 5-day periods. We’ve ranked these 5-day periods by their volatility of daily S&P index change, and grouped them into deciles from lowest volatility to highest.
The chart below graphs the cumulative return of all 5-day periods in each decile. It shows that those periods with the lowest volatility contribute the most cumulative gain, and as volatility rises, gains diminish and become losses.
So if it’s possible to predict volatility with reasonable certainty, then it should be possible to avoid some of the largest losses.
2. Certain information can be used to predict near-term equity market volatility
Consider volatility persistence. The below chart uses the same 5-day periods as mentioned above, but this time plots the S&P 500 index volatility of the next 5-day period (on the y axis) against the previous 5-day period S&P index volatility (on the x axis).
The positive trend line slope and R-squared of +0.42 demonstrate that even something as simple as last week’s volatility can be useful to predict future market volatility.
And because volatility is such a strong driver of losses, this means it is possible to predict higher likelihood of investment losses.
This is just an illustrative example. Our volatility prediction signals use more information than this to predict stock market volatility and the likelihood of large losses.
Our volatility prediction signals
Our proprietary volatility prediction signals for our active equity and active derivatives strategies update daily and will typically switch between bullish and bearish portfolios 10-20 times per year. We use mainly S&P 500 derivative instrument pricing as input, as well as other stock market metrics, to look for 4 key conditions in investor sentiment:
Strongly bullish sentiment
Extremely bearish sentiment
Sentiment trending more bullish
Sentiment trending more bearish
We would be delighted to speak with you more about our signals and how we use them to manage our active portfolios. Just click here to schedule a time to speak with us.