Extreme Volatility! How to exploit it?
Volatility is very important for all traders and represent one of the most key metrics to monitor for a trading system or a portfolio of trading systems, but too much volatility is usually not good be it for a single trading system, or for a portfolio of trading systems.
The reason is more often than not your trading system or portfolio will fall on the wrong side of it.
Volatility can be used in different ways in trading, like:
Generate an Entry/Exit signal
Define a market regime
Define a profit target
Define a stop loss
In this blog I will focus on how to use extreme volatility readings to exit positions or switch off trading systems and portfolios.
First let’s define volatility in terms of trading. It is a measure of how much the price is moving away from the average coupled with how much the bar range is expanding. If instrument price is suddenly making large swings up or down then volatility will spike. Basically we are measuring the variance of returns over a period of time
Lets look at the following example:
If you you have two trading systems with all metrics being the same except system one making 15% per year on average, with a standard deviation of 9% per year. While system two averaging 15% per year with 27% standard deviation per year. Assuming everything else is the same, then system one will be the better system to trade because it achieves the same returns with less volatility.
System one will return on average 6-24% per year, while system two will return -12% to 42% per year, yet both will average 15% per year. Check the graph below
Volatility is a big factor in pricing options for any financial instrument. Volatile assets are often considered riskier than less volatile assets. As traders our goal is to achieve the highest return for the lowest risk, so we can use volatility (represented by Standard Deviation or Average True Range) as a measure of risk.
Below you can see volatility for SP500 index represented in the VIX index
Vix index is real-time index that represents the market expectations of the sp500 price volatility over the next 30 days. It’s derived from options pricing on the index. It’s some times called the fear index because when it spikes it usually signifies uncertainty or fear in the market
Unfortunately we don’t have a Vix index for other instruments, so we have to build our own to get an approximate metric. There are many ways to measure instrument volatility, in this post we will use the standard deviation of daily returns and extrapolate that to one year and we do that by:
Calculating the daily changes of the instrument
Then take the standard deviation of the past 20 trading days (to match the VIX period)
Then we multiply it by the square root of (252) which is the number of trading days per year to get the annual number.
The result is called Annualized Volatility
from the graph below you can see how the indicator matches very closely the VIX index.
Based on Perry Kaufman research, each instrument has a different characteristic and there are average levels that describe high volatility for each asset and Perry suggest to exit the position if you have one and wait for another entry signal to get back in and if you don't have a position then switch off the system or portfolio until the levels get back down to normal levels.
Below are Perry's recommended general levels for different assets:
for single stock 90% annualized volatility is very high
for single futures, 50% annualized volatility is very high
for single crypto, 100% annualized volatility is very high
and for portfolio, 35% annualized volatility is very high
Screen shots of some financial instruments and their annualized volatility using Annualized Indicator that we built, are posted below:
You can code the indicator in Excel sheet or any programming language using the formula posted above. I did it in Easy Language for Tradestation or Multicharts you can download the open code indicators below for free, and once you import the indicator just verify it and insert in any daily chart to use.