A simple moving average. That’s the first thing you’ll learn in technical analysis boot camp. Over time, however, you’ll realize it’s a useless indicator. What is a 50-day, 100-day, 200-day moving average exactly? It’s just the past average price over a specific period giving you no read on the market’s future expectations.
Following chart prices and patterns tell you nothing about the internals of a complex system such as financial markets. If you’re an electrical technician you care about how a device calculates readings, not the reading itself. If you’re a weatherman, you care about how your model predicts the climate, not the climate itself. If you’re a Formula One racer, you care about how the car is configured, not what the dials on your dashboard tell you. The way you should think about financial markets is no different.
Renaissance Technologies founder, Jim Simons, realized only leading indicators predicted future moves in asset prices. In Gregory Zuckerman’s book, The Man Who Solved the Market, he told the story of how Simons made billions focusing on what most traders overlooked:
“Investors generally sought an underlying economic rationale to explain and predict stock prices, or they used simple technical analysis, which involved employing graphs or other representations of past price movements to discover repeatable patterns.”
After trial and error, Simons realized repeatable patterns on graphs were too simplistic to be useful. They confirmed trends, but that was it.
“Simons and his colleagues were proposing a third approach, one that had similarities with technical trading but was much more sophisticated and reliant on tools of math and science. They were suggesting that one could deduce a range of “signals” capable of conveying and useful information about expected market moves.”
When a market maestro worth $23 billion dismisses simple technical analysis indicators, you better listen up. Simplicity tends to attract herds. If everyone’s following the same dogma, be skeptical, be curious, be willing to look the other way.
Leading indicators, however, reveal what the market is expecting. Whether that’s sentiment, positioning, fear, or greed, they can become part of a system that calculates the most probable outcome.
Volatility is one of them. Why? Because it’s defined as “a statistical measure of the dispersion of returns for a given security,” or in layman’s terms, how the market expects the price of an asset to move in the future. “Future” is the keyword here. When you hear that, the light bulb in your head should turn on.
If volatility measures the scale of expected price movements, spikes in volatility spell disaster for the stock market. When you overlay the VIX index — the volatility index of the S&P500 — with recessionary periods, you’ll notice an elevated reading predicts a recession — or depression.
The VIX screams “sell, sell, sell” above 30. But it’s not just stocks that sell-off: it’s every asset class from long-term Treasuries to gold. This happened before the COVID-19 crash. Volatility in oil, gold, long-term treasuries skyrocketed, warning investors that markets were about to take a dive, and cash was king. Investors turning a blind eye paid the price as high volatility crushed even a supposedly hedged portfolio. The risk parity portfolio fell victim to a selloff in both bonds and stocks as the treasury market collapsed. The Treasury Volatility Index ($TVIX) rose to 16.4 — the highest reading on record.
When an asset’s volatility increases rapidly, that asset becomes uninvestable. We saw oil volatility reach record highs doubling the previous all-time high from 2008. What did the oil price do? It fell to a negative $40 per barrel — insanity. Would you want to invest in something when the market expects a 50%-300% intraday move? That’s not investing, that’s gambling.
Even if you’re passive investor holding a “diversified portfolio,” responding to volatility changes will save you money. It’s given investors a chance to get out before financial crashes and crunches. Leading up to the 2008 Financial Crisis, volatility told us the collapse of Lehman Brothers and a stock market crash was imminent, saving you a nice 50% if you reacted in time.
But can a simple moving average do that? Nope. It’s time to discard those backward-looking indicators that tell you nothing about the future. They are based on a flawed assumption: markets are linear. This is false. Markets are dynamic, complex systems that averages fail to explain.
Instead, monitor changes in dynamic indicators like volatility. There’s an index for every asset out there: $GVZ for Gold, $OVX for Oil, $VIX for Stocks, $EUVIX for Euros, etc., and you can track them — free of charge — via charting software available on most brokerage platforms. Setting an alert for a 100% move in volatility is a lifesaver.
Volatility is just one of many forward-looking technical indicators smart investors use to manage risk and identify major inflection points in markets.
But beware: If you decide to add extra indicators, make sure they’re actually forward-looking. Use this simple rule of thumb to filter the useful from the useless: Ask yourself, “Does this tell me what’s happening now or what’s going to happen in the future?” If it’s the former then cut it loose, if it’s the latter then you’re onto a winner.
The views represented in this commentary are those of its author and do not reflect the opinion of Traders Magazine, Markets Media Group or its staff. Traders Magazine welcomes reader feedback on this column and on all issues relevant to the institutional trading community.
