Friday, February 08, 2008
... you can boil index volatility down to two basic factors. One is the volatility of the component stocks, the other is the correlation between those very stocks. And they can very much offset each other. Imagine a world where half the stocks were moving violently and basically trending in one direction, and the other half was moving violently the other way. Index volatility would be very low as the moves would pretty much offset each other.
What we have now is the opposite. Stocks aren't that cosmically volatile, but they are all moving in relative unison. Ergo index volatility is theoretically *high* relative to individual stock volatility.
the sum of individual component absolute volatility -- such as true average range, for example -- and index volatility are different by the extent of cross correlation across the components. one could study the difference with an eye toward describing the degree of cross correlation, a high degree of which is sometimes described as a characteristic of troubled markets (though this would have to be shown or refuted empirically).