Surprise Facts About Market Volatility

01/19/2012 8:00 am EST

Focus: STOCKS

What is a "normal" day in the stock market? Since volatility is an aspect of any trading day, it is sometimes difficult to tell if the overall rise or fall on any particular day is meaningful or not. Here’s a brief analysis of this issue.

Volatility in the stock market simply means “change,” or fluctuation. (The fact that the word also refers to potentially violent situations or the ability of liquids to evaporate into vapor is an irony we will leave you to ponder on your own.)

Just as there are always waves of some kind on the ocean, there is always some fluctuation in prices in the market.

The final change at the end of each day is often simply a function of that particular day’s normal volatility. This is particularly true on days when the market is only slightly up or slightly down. If trading had not ceased at a specified time, a modestly up day might easily have turned into a modestly down day.

Nevertheless, there is a tendency to ascribe importance to each and every day’s change regardless of the volatility of that day’s action.

The mass media, in particular, tends to find a single event each and every day to brand as the driving force of that day’s movement, regardless of whether the size of the day’s change is significant. The mass media refuses to make a statement such as “There was nothing really significant happening in the overall market today,” even when such a statement might be the case.

See related: Why Traders Should Ignore the News

What level of price movement is needed to make a day “significant?”

To help answer that question, we gathered the data for every trading day in 2011 to see the frequency and range of daily market changes.

Volatility in the Markets in 2011

There were 252 trading days in 2011. We categorized each trading day by the closing price’s percentage change from the previous day’s closing price. We used the price of the Standard & Poor’s 500 Index (SPX) as our data source.

To concentrate solely on the volatility aspect, we used the absolute value of the days percentage change, meaning that a drop of -0.5% was in the same category as a rise of 0.5%.

The following table summarizes the number of days that fell into the categories we created.

chart
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There was only a single day with a change from the prior day of greater than 5% (August 8, 2011, with a drop of -6.7%)

What this data clearly shows is that most days—more than 60%—have changes from the prior day of less than 1%.

Again, more than 60% of all days in the market have movements of less than 1%. 

NEXT: A Mean-Reversion Trend Many Wouldn't Suspect

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Days with a Less-Than-1% Change in Price

Furthermore, these days are almost evenly split between up days and down days.

In 2011, 58% of the days with a less-than-1% price change showed a positive increase, while 42% of the days with a less-than-1% change were downward.

Since the overall S&P 500 closed out 2011 with an amazingly flat 0.003% change, the roughly even split between the days with less-than-1% movement is not surprising.

This fact also implies that days with movements of less than 1% are essentially meaningless as determinants of market direction. Often, the following day essentially negates the movement of the prior day.

In 2011, of the 156 days with price movement of less than 1%, a full 56 of those days were followed by days with price movement of less than 1%, but in the opposite direction.

This means that on more than one-third of the days with price movement of less than 1%, the following day essentially erased that market move and reversed the direction.

Furthermore, there are several examples where this type of non-action—back and forth oscillation— occurs for several days in a row.

Even worse, almost half (47%) of the days with less than 1% movement see the market direction reversed the following day, sometimes in very large percentage moves. 

This makes the price movement of a day with less than 1% in either direction almost meaningless with respect to predicting the market’s movement the next day. It is almost statistically equivalent to a coin flip.

What Is Meaningful?

Since a full one-third of the trading days have movements greater than 1% (in either direction), these are the days which ultimately prove to be the long-term drivers of the market. But even these days can wind up canceling each other out.

The price movements from August 4 through August 11 are probably the best example of this, as the following table illustrates.

chart
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It is interesting to note that both August 3 and August 12 showed price changes of 0.5%.

Conclusions

In general, a day on which the overall market moves less than 1% is not likely to be a significant…by itself.

A sequence of minor movement days, of course, all in the same direction, does have significance, but when a movement of less than 1% is reversed the following day by another movement of less than 1%, it should generally be viewed as just a “normal” market day.

After all, even on calm days, there are waves on the ocean.

Note: An important factor to note is that we have ignored volume in this brief introduction.

Higher-than-normal volume indicates a more significant directional move, while lower volume may have a significance of another nature.

We will have a more in-depth look at the market’s trading patterns, including volume and comparisons to years prior, in upcoming columns.

By Robert V. Green of Briefing.com

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