Volatility and bear markets are related: volatility “always” picks up when the market goes down. Is this good or bad for a trader or investor? Should you buy or sell stocks in a volatile market? Let’s find out:
Short-term traders should continue doing business as usual. Long-term investors should buy – not sell.
Very few traders have a bear market trading strategy or a bull market trading strategy, something that makes sense. Normally, we make backtests based on time series over at least a couple of business cycles, and thus it involves both bull and bear markets.
Volatility, the 200-day moving average, and VIX
However, a bull market normally lasts much longer than a bear market. We like to use the 200-day moving average to separate a bull and bear market and the fact is that since 1960 the market has spent 70% of the time above the 200-day moving average.
A bear market is often short and has a spike in volatility, which for many is scary. The ultimate scare happened in March 2020 when covid struck and we witnessed jaw-dropping volatility. This was for many a scary experience (also for us) and we assume many traders either cut down the size of positions or stopped trading altogether.
When you have a volatile market, you most likely are in a bear or falling market. Just look at the graph below:
The upper pane is SPY (S&P 500) and the lower pane (red line) is the VIX. As a general rule, when the market drops, volatility (VIX) goes up. Stocks and volatility are inversely related, but at the same time volatility is very mean reverting.
Relevant VIX articles including trading strategies:
- Using VIX To Trade SPY And The S&P 500 (VIX Trading Strategies)
- WilliamsVixFix Explained – Does It Work? (Including trading strategies)
- 4 VIX trading strategies – What Is The VIX And How Does It Work?
- Williams Volatility Channel — What Is It? (Trading Strategy)
Should You Buy Or Sell Stocks In A Volatile Market? Long-term investors (Backtest)
This is an easy question to answer. If you’re a long-term investor and have at least five years until you are going to withdraw money from your account, you should buy when volatility picks up – not sell.
The reason for this is simple. When volatility is high you are most likely in a bear or down market. Average gains are slightly higher in the next 8-24 months than average, thus you are smarter if you buy and not sell.
However, the longer you hold, the more likely you are to get the average long-term returns, no matter what kind of market regime you bought into (please read buy and hold vs market timing).
Should You Buy Or Sell Stocks In A Volatile Market? Short-term traders (Backtest)
Let’s backtest our monthly trading edge for August 2021. We leave the rules for our paying subscribers, but the strategy has (of course) strict trading rules and settings that make the strategy 100% quantified and not left to discretionary judgment. How has the strategy performed in different market environments? What is the historical performance like?
First, let’s look at how the strategy has performed overall since the year 2000 (we backtest QQQ – the ETF for Nasdaq 100):
The best period is the bear market from 2000 to 2003. Also, both the financial crisis in 2008/09 and March 2020 were good trading environments for the strategy.
(To understand more about bear markets we recommend our separate article called anatomy of a bear market.)
Let’s split our backtest into two parts: we only take trades when the close is above the 200-day moving average and in the second backtest we filter trades when the close is below the 200-day moving average.
Why the 200-day moving average? Because we know from previous backtests that the volatility is substantially higher when both SPY and QQQ are below this average. For SPY it is like this:
- Above the 200-day moving average: volatility is 1.05%
- Below the 200-day moving average: volatility is 2.1%
Read more about the 200-day moving average and volatility.
Should You Buy Or Sell Stocks In A Volatile Market? Above the 200-day moving average
We use the same trading rules but we filter for trades that are only ABOVE the 200-day moving average:
The average gain per trade is 1.05%, profit factor is 2.9, and the Sharpe Ratio is 3. The strategy performs pretty well.
Should You Buy Or Sell Stocks In A Volatile Market? Below the 200-day moving average
Let’s switch to filter trades that are only BELOW the 200-day moving average:
The average gain per trade is 2.35%, the profit factor is 4.3, and the Sharpe Ratio is 4.2. Even if we exclude the first 5 years of the data the average per trade is still a solid 1.6% – substantially higher than when above the 200-day moving average.
All the trading performance metrics improve when volatility is high!
Short-selling and volatility
Also worth noting is that short strategies in the stock market tend to improve during a bear market, and thus indirectly when volatility picks up. Please read more in a separate article called is it possible to make money shorting?
List of free trading strategies
If you are interested in trading other strategies, we have compiled a very long list of trading strategies. We also have the Amibroker code for all these hundreds of strategies (also in plain English for Python backtesting):
Should You Buy Or Sell Stocks In A Volatile Market? Conclusion
As a long-term investor, you should buy in a volatile market.
If you are a short-term trader, you should continue as usual and don’t do anything (but of course make sure you are safe from the risk of ruin). Traders both buy and sell in a volatile market, but most likely your trading strategies improve in an environment of increased volatility, although it feels counterintuitive for many.