The Volatility Optical Illusion

Written by Michael Bigger. Follow me on Twitter.

The stock market is a great optical illusion. When prices march much higher, volatility decreases but instability in the system increases. The opposite is true after a big fall. Volatility is high but stability increases.

These statements lead us to state the following dualities:

• Perceived instability is stable.
• Perceived stability is unstable.

  

What are some of the signs we believe indicate instability?

• Low implied volatility.
• A P/E ratio much higher than historical levels.
• Lower than typical implied options correlation.
• A decline in dividend yield. 
• Your cab driver is talking about stocks.

 What are some of the signs indicating a stable market?

• High implied volatility.
• P/E ratios comparable to or lower than historical levels.
• High implied options correlation.
• An increase in dividend yield.
• Panic in the market.

We have been fooled many times by Mr. Market. Have you?

Comments

[Steve Place]

Stable is the last thing i'd call 2008, when the VIX was in the 50-70 range.

I'd say that perceived instability is stable...eventually.

[Michael Bigger]

Exactly.Eventually the kinetic energy dissipates.

[Michael Bigger]

An unstable stock market like we had in 2006 was non volatile. Stability refers to the amount of potential energy in the system.