The Basics

Looking at Volatility Across Markets

The other day I commented on a post on a personal finance blog. The article was an introduction to forex. I won’t link to it here because it was very poorly done, falling short on many points. One of the things that tripped off alarm bells early on about where the post was going was this statement:

However, it is important to note that forex trading is rather risky, and the currency market is quite volatile.

All trading is rather risky, so I won’t address that particular point. I will, however, speak to the issue of the currency market being quite volatile. Statements about the forex market being more volatile than others are made all the time – almost always by folks who are putting forex trading down in some fashion or another. As I’m going to show you, the numbers make it pretty clear that forex is in fact on the low end of the volatility scale when looking at all markets.

Here is a look at the last year worth of volatility in forex rates

Pair Daily StdDev Avg Daily Rng
EUR/USD 0.93% 1.41%
USD/JPY 0.91% 1.45%
GBP/USD 1.00% 1.65%
USD/CAD 1.02% 1.60%

The first column is the standard deviation (a commonly used volatility metric) of the daily % change for the one-year period beginning November 1, 2008. The second column is the average daily range, with each day’s range being expressed as a % of the prior day’s close ( [H-L]/C ). I went with % changes and ranges to make things directly comparable across markets. So from this data we can see that USD/CAD tends to see the biggest daily changes, though GBP/USD tends to have slightly wider daily ranges.

Now let’s compare that to the major US stock indices.

Index Daily StdDev Avg Daily Rng
Dow 2.01% 2.41%
S&P 500 2.26% 2.60%
NASDAQ 100 2.18% 2.69%
Russell 2000 2.89% 3.28%

Here we can see about what as we would expect in terms of the small cap Russell index being the most volatile in terms of both price changes and ranges.

And how about individual stocks?

Stock Daily StdDev Avg Daily Rng
IBM 2.18% 2.85%
GE 4.20% 5.59%
AAPL 2.66% 3.44%
GOOG 2.51% 3.33%
AMGN 2.33% 3.03%
XOM 5.95% 6.66%
JPM 2.23% 2.88%
KO 1.74% 2.45%

All of the above are clearly large-cap stocks which would generally be expected to show less volatility than mid- or small-cap stocks (as witnessed by the higher volatility in the Russell index). Even still, with the exception of KO, they are all much more volatile than the forex pairs.

So what about commodities?

Commodity Daily StdDev Avg Daily Rng
Gold 1.61% 2.38%
Oil 4.35% 6.01%
Nat Gas 4.91% 6.54%
Corn 2.70% 3.83%

Again, the commodities are clearly much more volatile on a day-to-day basis than are forex rates.

Now to add in a market that’s considered the least risky by many folks – interest rates.

Instrument Daily StdDev Avg Daily Rng
Eurodollar 0.05% 0.06%
2yr Treasury Note 0.13% 0.18%
10yr Treasury Note 0.63% 0.92%
30yr Treasury Bond 0.99% 1.50%

I’m using the futures for the prices above. Finally we have a market where volatility is lower than forex! As you can see, the shorter maturity instruments (Eurodollars are 3mo) are calm compared to the others we’ve looked at here. Bonds, though, are in line with the volatility readings we see for the forex pairs.

So the bottom line is that not only are forex prices NOT the most volatile, they are actually on the lower end of the spectrum when looking at available markets. The numbers demonstrate it pretty clearly, even in a 12-month period which has seen its fair share of volatile trading.

Now granted, the application of leverage in forex creates the opportunity for very high levels of volatility in one’s trading account – but that’s not the market’s fault. Traders don’t need to use leverage. You can trade forex without it.

The Basics

The implications of index trading

Something came up recently in one of the forums I visit from time to time. It had to do with indices and the implications of trading them in terms of their component stocks. I’m sure others have similar questions, so I thought I’d tackle the subject here.

Firstly, it is worth taking a look at what an index is. There are so many of them and they are the first thing many folks think of when considering the stock market (and others as well). A stock index is nothing more than a mathematical construct which is used to track the change in value of a collection of component stocks. For example, the Dow Jones Industrial Average (DJIA) comprises 30 stocks that have been chosen to be representative of the health of the US industrial complex. When the price of a stock in the DJIA index changes, the index changes.

Now it is worth considering that indices were created at a time when the only way to trade them was to actually buy all of the stocks which are included. With the advent of a number of new financial instruments, though, one can now actually trade an index without doing transactions in the underlying shares. That can be done through futures, options, and exchange traded funds (ETFs), among others vehicles.

With ready index tradability, no longer is it the case that only changes in the price of the underlying stocks can change the value of an index. Now an index can change through direct action in it. When that happens, the directional action then gets translated through in to the component stocks. This is done by arbitrage type of activity whereby institutions buy or sell big baskets of shares all at once.

So the question that I recently saw brought up was whether owning an index means ownership of the stock. In the old days it would have. These days it does not necessarily, at least not directly. That said, though, if you own the DJIA, somewhere along the line the 30 stocks are being held. If you own an ETF you own part of a fund which holds the stocks. If you are long the futures, chances are that somewhere long the line there is someone holding the shares as a hedge. Same with index options.

I think the real question that was asked on the forum in terms of share ownership was whether the component stocks influence the index. The answer to that question is “of course”, since the “cash” index is still calculated based on those stock prices. We must now, however, add in to the equation the fact that the index can also influence the prices of the shares in them. It’s a two way street now.