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VOLATILITY AND ASSET PRICES
We had a question in our webinar today about the correlation between volatility and different asset classes and why it’s important for us as traders.
RECOMMENDED READING: VOLATILITY AND ASSET PRICE CORRELATION
Now looking at volatility, obviously volatility can be a good and a bad thing. We want volatility in the market because without volatility we won’t have any price moves to really benefit and make money from.
However, bad volatility or high volatility can be a real risky environment to trade and navigate in the markets.
Now normally when we see fear and anxiety and uncertainty coming into the market we normally see volatility spike to the upside. And whenever we see greed and complacency, we normally see a lower volatility range or muted volatility in the markets. Now the reason why volatility, especially spiking volatility, can be so dangerous is because volatility basically tells us that there’s a big increase in the potential price range, the daily price range or volatility range, for a particular asset class.
So if the volatility suddenly spikes up drastically it means there’s a big chance of seeing bigger moves to both the up and the downside in any given day, which makes it very difficult and risky to navigate and trade those particular asset classes. Normally, the volatility range that is used for the equity markets as a whole is the VIX. Now the VIX actually tracks the options pricing for the S&P 500 in terms of the 30 day contracts.
Meaning that it’s not really a gauge of the actual or the historical volatility. It is a gauge of the expected volatility of the S&P 500. Now even though it only tracks the S&P, it is normally a good gauge, as we said, for the overall equity market.
Now just looking at the correlation between those two, there’s normally a strong inverse correlation between volatility as well as its asset class. So whenever we see a spike to the upside in volatility we normally see a spike to the down or a move to the downside in the corresponding asset. Whenever we see that spike to the upside, spike to the downside, et cetera.
Now the good news is apart from the VIX that tracks the equity markets or the S&P as a whole, we do also have volatility indexes for other asset classes. For example we do have OVX. Now OVX basically tracks the volatility of the oil market. So there you can see that same type of inverse correlation. Whenever you have those big spikes to the upside in OVX you see big moves to the downside in oil. Big spike to the upside in OVX, downside in oil. You also have the GVZ. Now the GVZ basically tracks the volatility for gold. And if we just quickly overlay those two on the chart we can see that same type of reaction.
Spike to the upside in volatility, the move down in gold. Spike in volatility, move down in gold, etc. Now the way that we can use this in our trading, obviously we often do inter-market analysis so we want to see what the equity markets, the commodity markets, are doing for us to know whether we are seeing a strong risk on or a risk off tone.
So whenever we see a spike to the upside in volatility indexes, that is normally indicative of a strong risk of flow meaning that we can expect the high beta commodity-linked currencies to weaken and the safe havens to appreciate. And whenever we see muted and low volatility we basically expect a more risk on tone meaning that we’ll expect the high beta commodity-linked currencies, like the Aussie, the CAD, the Kiwi, to appreciate. And the safe havens, like the Japanese yen and the Swiss franc to basically remain pressured.
Whenever we have very big global uncertainty, like we had back in the global financial crisis, you normally see cross-asset volatility spike to the upside and that is normally why you see so many dislocations in terms of normal price correlations.
So the reason why you’re seeing some of those dislocations more recently is you can see these spikes that we’ve had in the volatility indexes from this recession fears we’ve had from the coronavirus.
So that is just a quick example, a quick lesson, on why volatility is important, why it has that inverse relationship in terms of the different asset classes and how we can use it in our trading as currency traders to basically make better decisions, especially when we analyze the overall risk tone of the market.