Volatility Compression

Last Updated :

21 Aug, 2024

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Table Of Contents

What Is Volatility Compression?

Volatility Compression refers to that period or phase when the fluctuation in an asset or financial market diminishes considerably, as evidenced by its historical performance. Hence, during this timeframe, the asset prices don't rise or fall much and tend to remain constant.

Long-term investors and short-term traders watch the volatility compression pattern to modify their strategies for reaping maximum profit in a low-volatility environment. However, in such a situation, the market players may falsely predict market stability, overlooking the fact that the opportunities to make a profit in such a financial market fall simultaneously due to little price movements.

What Is Volatility Compression?

Volatility compression is a period that marks a decline in historical volatility or fluctuation in asset prices or financial market performance.
It is often followed by a significant market movement, whether upwards or downwards.
It is often driven by reduced economic activities, low interest rates, a decline in trading volumes, and shifting market sentiments.
The low historical volatility in the financial market and asset price can significantly impact traders and investors by resulting in a false sense of market stability, limited trading opportunities, and nominal profits on asset trading.

Volatility Compression Explained

Volatility compression is a significant contraction in the historical volatility of the financial market or asset price during a specific period. Volatility refers to the standard deviation of a return series measured over a specific timeframe or determined using other methods, such as the range of price bars or implied volatility from options pricing. Traders often keep an eye on the volatility compression breakout indicators to know what's coming next. A shrink in market volatility near support suggests caution before buying breakdowns, as sharp moves are likely to continue. Thus, it can be perceived as the market calm before a significant movement in asset prices or market trends.

However, volatility compression cannot be directly observed like price and may vary based on the timeframe or measurement method used. A highly volatile market is assumed to involve more risk or uncertainty. However, a market with volatility compression cannot be considered favorable as well since the traders and investors may only be able to book high trading profits if they change their trading strategy to suit the low volatility pattern.

Understanding volatility behavior can help investors protect their portfolios and make informed trading decisions. However, it requires them to devise suitable trading strategies to make a profit even when the market volatility is shrinking. Thus, in such a scenario, the traders may focus on trading other types of securities that are not influenced by such compression, like bonds, treasuries, foreign market securities, etc. Also, they can hinge on options trading, which works best during the low volatility period. The other strategies can be diversification or waiting till the market becomes stable or normal.

Factors

The shrink in market volatility usually occurs for a short-term period. However, it sometimes indicates the onset of a significant market uptrend or downtrend. It can result from various market-related and macroeconomic factors, including:

Decline in Economic Activities: Volatility compression can result from reduced economic activities or falling Gross Domestic Product (GDP) in the nation.
Low Trading Volumes: When there are a limited number of buyers and sellers in the financial market, there is a significant decline in the trading volume, resulting in low volatility.
Change in Market Expectations or Sentiments: Sometimes, the investors prefer to wait and watch the market, thus reducing their trading activities.
Low-Interest Rates: Even when the investors or traders are neutral to the changing monetary policies or low-interest rates, there can be a decline in the historical volatility of the market.

Examples

The concept of low volatility in the financial markets is not new; however, with the development of various volatility indicators, the market participants can now predict the same with precision. Below are some of its real-world examples:

Example #1

Suppose the S&P 500 index has been stable for the last ten days. Also, most of the leading components of the index have not shown a significant fluctuation, indicating a volatility compression as determined by the Volatility Index (VIX). Now, the experts believe that the situation is temporary, and the market uptrend will follow this low volatility period. Thus, they suggest traders and investors hold their position until then. However, long-term investors can adopt the diversification strategy to mitigate the risk of such compression.

Example #2

Bitcoin hovers around the $17,000 mark, showing minimal fluctuations, with a 1.5% dip in the past day and a 2.5% decrease over the week. The total cryptocurrency market cap dips slightly to $854 billion, evoking fear among investors according to the Fear & Greed Index at 26 points. Moreover, speculative interest dwindles amidst regulatory changes and stagnant growth, though long-term buyers' eye potential amidst the cautious atmosphere. There is a decline in Ethereum and other blockchains in developer activity, except for the Arbitrum network.

The Crypto-Assets Environmental Transparency Act and SEC release and mandate regulatory updates in the US, alongside EU measures imposing cash payment limits and audits on crypto transactions to curb illicit activities. Overall, the crypto market navigates through volatility compression and regulatory shifts, maintaining a cautious stance amid uncertain circumstances.

Effects

Although the volatility compression is a temporary period, it considerably affects intraday traders and long-term investors in the following ways:

1. Limited Trading Opportunities: The intraday or short-term traders may need more room or opportunities for successful trade in a market with low volatility.

2. Low Profitability: The traders cannot book huge profits when trading in the contracting volatility market scenario due to the low margin of price movement.

3. False Sense of Stability: The investors may perceive that the market is stable or secure and that it is easy to predict stock prices. However, a decline in volatility can be an indication of a potential uptrend or downtrend.

4. Changing Trading Strategies: The traders and investors who effectively gauge the volatility compression pattern change their trading strategies to ensure desired returns.

Frequently Asked Questions (FAQs)

How to trade volatility compression?

Short-term traders can often bet on options trading strategies to win in periods of volatility compression in financial markets. They can even make use of algorithm trading and alternative high-frequency trading strategies to mitigate the low volatility risk efficiently. Moreover, investors can opt to diversify their portfolio across bonds and defensive stocks since they are least affected by market fluctuations.

What is a volatility compression breakout indicator?

The volatility compression breakout indicator is the various volatility measures that determine the low volatility phase in the market, which is often followed by immense trading opportunities. Thus, it predicts a consecutive period of market expansion that would break out after the temporary period of stability in asset price movement.

How to examine a period of volatility compression?

The various volatility indicators that facilitate the identification of low historical volatility in the financial markets include the Volatility Index (VIX), Bollinger Bands, Relative Volatility Index (RVI), Donchian Channel Indicator, and Average True Range Indicator (ATR).