Historical Volatility and One Year Returns

When speaking about options, I have a habit of glossing over historical volatility and focusing on implied volatility. After all, implied volatility is the basis for the VIX calculation and historical volatility, well, for the most part I tend to regard it as a historical artifact that may or may not provide some insight into the current level of IV.

TradingMarkets.com, however, had some very interesting things to say about historical volatility in an article published last week that bear repeating here. In an article co-authored by Larry Connors (to my knowledge, the only person who has published a book [out of print, unfortunately] dedicated exclusively to the VIX: Trading Connors VIX Reversals), TradingMarkets.com presents their research on 100 day historical volatility patterns and subsequent one year performance for 11,000+ stocks from the period 1995-2007.

Their conclusions may surprise many traders and are certainly worth pondering. In looking at buckets of the 10% and 20% most volatile stocks and comparing these to buckets of the 10% and 20% least volatile stocks, the authors determined that the least volatile stocks were almost twice as likely to be trading higher one year later and, on average, had one year returns more than double (14.7% to 7.3%) their high volatility counterparts.

As an interesting historical footnote, Connors and co-author Cesar Alvarez point out that the lower volatility buckets outperformed the higher volatility group for the entire period studied, with the exception of the middle of 1998 through 1999, during which time the dot com boom phenomenon overrode the tendency for the higher volatility stock to be the laggards. Of course, if you were to remove this period from the study and focus on the remaining 11 years, the superior performance of the lower volatility stocks would be even more impressive than the statistics quoted above.

So the next time you make a lot of money trading those high volatility stocks, make sure you put your profits into a low volatility long-term portfolio…and if the high volatility stocks start to outperform their slow and steady cousins, consider a defensive portfolio. [Bonus points to any reader who comes up with the best ratio chart available on StockCharts.com for comparing high volatility stocks to low volatility stocks.]