Over the past month, I’ve introduced the concept of volatility based on the closing price of the ASX200 each day or each week. While that understanding is of major importance in managing a share portfolio, there are three other measures of volatility that are needed to get the most out of measuring uncertainty.

1. Intraday volatility
2. The VIX, or fear index
3. The disorder index

Intraday volatility

Let’s look at this example: the market fell from about 6,800 in early November 2007 to just above 5,100 in late January 2008. It then rose to above 6,000 on 4 February 2008 before it again retreated.

As I show in the chart, the market rose about 170 points before morning tea on that day only to fall 193 points before rallying back above 5,850 at the close.

Chart: Intraday variation on the ASX200 on 4 February 2008 

Volatility measures that only use end-of-day pricing would consider that day to have been quiet and mildly positive (up 14 points). But to anyone watching the screen that day – as I was – it was a terrifying experience. As a result, I devised a measure of excess volatility – or fear – that represents intra-day movement outside the close-to-close prices. I update my fear chart each week on myWoodhall Investment Research website.

The VIX

There is a commonly used ‘fear’ index for the S&P 500 called the VIX. It measures implied volatility from options taken on that index. The argument is that when traders fear a fall, they want to use put options to limit their losses and this activity increases implied volatility. Recently, the ASX has created an ‘Aussie VIX’ for our market. I obviously prefer my measures, but I acknowledge the usefulness of the VIX versions.

My analysis leads me to an important conclusion. When fear is high, expensive markets can fall rapidly and overshoot, and cheap markets can fall further and/or stay cheaper for longer. I will discuss my mispricing measure at a later date and go into more detail on my fear index next time.

The disorder index

A third additional measure of volatility is derived from co-movements of stock or sector returns on a given day. For example, the returns of the 11 major sectors often go up or down together. In that case, cross-sectional volatility – which I call disorder – is low. When returns go in opposite directions, or quite different orders of magnitude in the same direction, disorder is high. I update the disorder index each day and put the time series on my website each week.

When disorder is high it is likely that investors are jumping in and out of sectors making it difficult to know where the market – or your portfolio – is heading. In my view, this is another variant of fear and I use my disorder measure to confirm or otherwise what my fear index is saying. But the important thing for me is that I have an objective measure of market sentiment. I have used these tools every day for years to better understand what to do – if anything.

Since the beginning of the year, volatility, fear and disorder have behaved as they did before the onset of the global financial crisis (GFC). So even as the French and Greek elections play out, I feel that our market is more likely to take bad news in its stride than it otherwise would have done. Had these fear measures been high, I would have sold more than I did last week to be ready to buy back in at a later, more peaceful date.

Ron Bewley is the Executive Director of Woodhall Investment Research.

Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Anyone should, before acting, consider the appropriateness of the information in regards to their objectives, financial situation and needs and, if necessary, seek professional advice.