By the time I was 10, summer was for three things: mowing lawns for spending money, playing little league baseball because everyone else did, and shooting hoops because that’s what I loved.

Basketball games are played in the winter. Basketball players are made in the summer. Like all sports, improvement is made in the off-season—which I did summer after summer. By the time I got to high school, I was a good shooter. To this day, it’s safe to say that I’m a better free throw shooter than a majority of NBA players (who statistically make right around 75% of their free throws).

When I played high school ball, each basket was only worth two points. Without a 3-point shot, the big guys under the basket mattered most because they could rebound and score close to the basket.

By 1986, though, colleges and most high schools had adopted the 3-point rule, and that change made all the difference in the world for shooters like me. Shorter players who could shoot were suddenly as important as tall ones. After this structural change, the game of basketball changed, and for the better. The game became more balanced as teams had to spread out all over the court to create longer shots on offense and defend against them when the other team had the ball. Those who adapted to the change found the most success.

The same can be said for the financial markets. A structural change is occurring before our very eyes. Those who adapt will find success. Those who don’t will struggle.

When Markets Change

By and large, markets undergo structural changes because of outside influences. The general ebb and flow of financial markets has been similar since the beginning of organized trade because it is driven by the psychology of buyers and sellers. But modifications to that general ebb and flow are brought on by environmental changes.

Here are some examples:

• Regulatory Changes:
  
  • January 1997—Order handling rules changed and opened up data access execution channels to retail traders and spurred the Day Trading revolution.
    
  • 2001—Stock prices were stated in tens of cents rather than fractions of a dollar. The change was referred to as decimalization, and scalping of the bid/ask spreads ground to a halt for small volume traders.
    
• Monetary Policy Changes:
  
  • 2002 – 2004—Greenspan expanded credit even with recovery underway, which then led to a real estate bubble and a four-year bull stock market without a single 10% correction.
    
  • March 2009 – May 2011—The real estate bubble/debt crisis bailout fueled the rally.
    
• Technology Changes:
  
  • 1920s—The telephone reduced trading cycle response time in Jessie Livermore’s era.
    
  • 1995 – present—The Internet has reduced news cycles and, therefore, trading cycles.

These are just the first few environmental changes that came to mind. Clearly there are many other examples and probably even more significant ones out there!

What we are experiencing now in the markets is a combination of all of these outside influences: regulatory, monetary, and technology changes have combined to reduce cycle times and expand volatility. Today we’ll concentrate on the volatility issues and leave the cycle time reduction for future discussion.

The Volatility Explosion and a Tool to Measure It

There are many ways to measure volatility in the financial markets. My favorite day-to-day tool is Average True Range. But to understand the amount of “fear” that is priced into the market, many analysts look to the CBOE Volatility Index, popularly known as the VIX. I use the phrase “priced into the market” because VIX measures the relative dollar amount of premium that option writers are demanding in order to sell puts or calls.

Let’s take a moment to understand how VIX is calculated and then look at what it is telling us about the changing response of the market.

According to the CBOE, the stated goal of VIX is to represent expected volatility for the next 30 days, but it is then annualized. Trying to understand the exact number is a bit tedious, so let’s jump to the numbers that analysts have traditionally used: a VIX over 30 is usually considered high, meaning that fear is running high in the market and an upward move in price is expected.

We saw high volatility in the markets in the during the 2008 – 2009 real estate bubble melt down and again from August 2011 to now with the European debt crisis and US rating downgrade. Has this been normal, according to market history, or not?

Looking at VIX readings dating back to 1990, we can see that this is not normal at all! Let’s put together some numbers for some meaningful periods dating back to the beginning of the reported VIX. Here is a list of the number of weeks where the majority of the range of the VIX for the week was above 30:

• 1990 – 1999 (10 Years): 21
  
• 2000 – 2003 (4 Years): 36
  
• 2004 – 2007 (4 Years): 0!
  
• 2008 – 2011 (~4Years): 60

So we can get a feel for this, here’s a “mashed-up chart” that shows this whole period.

To see how well the VIX describes market history, look at the chart from last week’s article.

We’re seeing more periods of high volatility, and they are lasting longer. The exception was the monetary easing bull run from 2003 – 2007 when the market never even had a 10% pullback. The VIX reflects the comfort and complacency that existed during that run. Since the real estate/credit crisis, however, massive global cash infusions have scared market participants on both ends of the spectrum. They’re scared to miss out on the next big move up, so they jump in boldly when prices start moving up. But they’re also scared that the market could plunge, so money is extracted quickly at the first signs of downward price pressure. This leads to the rapid up and down movements that have characterized the markets over the past four years leading to twice as many high volatility weeks than we’ve seen for similar periods over the past 30+ years.

All the extra cash that has been injected into the system has combined with the contracting news cycle times to give us a market that is likely to retain its higher levels of volatility into the future.

Just as the basketball world adjusted to the 3-point shot, traders and investors have to adjust to a world of faster news cycles and considerably more money chasing the same number of assets.

I’d love to hear your thoughts and feedback—just send an email to drbarton “at” vantharp.com. Until next week…

Great Trading,
D. R.

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