Markets have moods.
One day, stocks are crashing and week after week prices swing up and down rapidly. But then, just as mysteriously, things quiet down, and we drift into weeks of sleepy, boring trading.
Volatility clustering is just a fancy way of saying that big moves tend to come in bunches. When markets get volatile, they usually stay volatile for a while. When they’re calm, they stay calm for a while.
Picture it like weather: A sunny day rarely explodes into a hurricane overnight, but once the storm hits, it lingers, spawning more rain and wind.
If you look at daily percentage changes in this graph you’ll see long, sleepy stretches followed by bursts of volatility.
That’s volatility clustering. It’s the heartbeat of market stress.
Why It Happens
Psychology doesn’t reset overnight.
After a shock, traders stay tense. The first time they see a dip, they buy it. The second time, they hesitate. By the third, they’re cutting risk. That tension keeps volatility elevated long after the original event.Leverage creates forced behavior.
When volatility spikes, so do margin requirements. Levered players are forced to sell which keeps prices swinging.Algos amplify feedback loops.
Many strategies automatically adjust exposure based on recent volatility. If the market starts moving, those systems start selling.
Why it Matters
Strategies behave differently across different volatility clusters.
A system that performs well in low volatility often breaks down in high volatility. That’s why in our backtests, we always bucket results by volatility regime — low, medium, high. It’s like testing strategies in three different worlds.
By spotting these patterns, we can tilt the odds in our favor. Recognizing when the market is shifting between volatility clusters is key to making profits.