Volatility is often a good contra-indicator: when share prices are rising and everyone is positive, it may well be time to become cautious. Conversely, when share prices drop, volatility increases, fear abounds and investors are pessimistic, it is often a good time to buy equities.
There are several ways to measure volatility. One of these involves calculating the number of days out of the previous 20 trading days on which an index or share price has moved more than one percentage point up or down.
For example when the ALSI reached a high in October 2007, and an all-time high in May 2008, there were very few days on which the market moved by more than one percentage point (i.e. less than 10%). As the market started to decline, volatility spiked to a level where the number of days with market movements exceeding one percent occurred more than half the time.
During the crash of 2008 the number of days rose to as high as 11. When the number of days reached or exceeded 10 (such as in October/November 2008 and March 2009), indicating a significant amount of volatility on the back of negative investor sentiment, good buying opportunities presented themselves.
Furthermore, after the market became extremely oversold in March 2009, short, sharp spikes to a level of six days (early April 2009, late June 2009 and late January 2010) also proved to be good buying opportunities. A significant decline in the number of days to below one (December 2009 and March 2010) indicated short-term overbought conditions and preceded a pull-back in the ALSI.
So what does this tell us about our current situation? Volatility recently spiked again to a level exceeding six days out of twenty, but has since retreated to approximately five. While this spike could prove to be another buying opportunity, erring on the side of caution for now would seem to be the prudent strategy as there is still a significant amount of uncertainty in financial markets.
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