Don’t be fooled by low volatility

Just because realised volatility is low in many developed equity markets doesn’t mean things are calm below the surface. Extreme moves at the edges of the distribution of returns compared with the middle reached a record high this year.

Realised volatility is low

It is widely understood that the realised volatility in equity markets has been low in recent years. In 2017, for example, the S&P 500 index only moved more than 1.1 per cent in a trading session five times, well below the annual median of 47 such days since 1989.

As can be seen in Figure 1, the number of daily trading moves in excess of 1.1 per cent – the standard deviation of daily returns since 1989 – has been falling post the financial crisis, with last year being extraordinarily unusual. So far in 2018, there have been 30 moves greater than 1.1 per cent, suggesting a normalisation of sorts.

Meanwhile Figure 2 looks at volatility as a standalone measure of risk and it can be seen that the line is also depressed relative to history. Notwithstanding the rise so far this year, the average level for 2018 is still below the 30th percentile of volatility over the period.

Realised volatility tends to move between low, medium and extreme regimes. In the chart below, the darker band - the interquartile range - marks periods of medium volatility, as per much of the post-financial crisis period. More extreme levels of volatility occurred during events such as the dot.com and financial crises, or the eurozone wobbles in 2012.Low readings, as experienced recently, accompany benign markets. In other words, US stocks are currently trading slightly above the lowest quartile of realised volatility.

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