In the last four years, equity markets have been showing a very interesting cyclical pattern, which I haven’t seen in the years or even decades before: volatility “shocks”, followed by strong low-volatility rallies. The following chart shows how this pattern occurred after the Financial Crisis. Note how each of the two phases takes several months to play out. While transitions between high to low volatility areas happened smoothly, changes in the opposite direction were quite dramatic. Most notable was of course the transition that ended in the Flash Crash in 2010:
The lower pane of the following chart shows short-term volatility over a 20 years period. Without looking into too much detail, it becomes clear from the ATR distribution that this extreme high/low volatility cycle did not occur prior to 2006. Of course, volatility shocks happened, but the difference between high and low was much smaller than in recent years:
Finally, here is an example from the rally between ’95 and ’98, showing no volatility shocks at all:
It is not clear why this pattern has been so obvious in recent years, but the 2010 Flash Crash hints that the high degree of algorithmic trading is one of the culprits. As we all know, markets always change. And that’s the reason why I do not like automated trading strategies. It is quite obvious, why a strategy that might have worked in the nineties probably doesn’t work anymore. It is much easier for discretionary strategies to adapt to changes in market structure.