The market gyrations of late are interesting, especially during the NCAA Basketball tourney. Normally, volatility declines when these games are on during the week, as traders watch their brackets as much as they do the market (I’ve seen quantitative analysis that says this isn’t actually true, but I’m skeptical since I’ve been there and I can promise you – the televisions on the trading floor are tuned to the NCAA, not the CNBC, on those days). Higher volatility not only implies that lower prices are appropriate in theory but it also tends to happen in practice: higher actual volatility tends to force leveraged traders to reduce position size because their calculation of “value at risk” or VAR generally uses trailing volatility; moreover, these days we also need to be cognizant of the small, but still relevant, risk-parity community which will tend to trim the relative allocation to equities when equity vol rises relative to other asset classes.

My guess is that the risk-parity guys probably respond as much to changes in implied volatility as to realized volatility, so some of that move has already happened (and it’s not terribly large). But the VAR effect is entirely a lagging effect, and it’s proportional to the change in volatility as well as to the length of time the volatility persists (since one day’s sharp move doesn’t change the realized volatility calculation very much). Moreover, it doesn’t need to be very large per trader in order to add up to a very large effect since there are many, many traders who use some form of VAR in their risk control.

Keep in mind that a sharp move higher, as the market had yesterday, has as much effect on VAR as a sharp move lower. The momentum guys care about direction, but the VAR effect is related to the absolute value of the daily change. So if you’re bullish, you want a slow and steady move higher, not a sharp move higher. Ideally, that slow and steady move occurs on good volume, too.