Perhaps one of the most difficult decisions faced by discretionary and system traders is how to allocate capital effectively to get the most bang for the buck. In other words, how do we choose which stocks to trade? Of course most traders will have a method (could be technical or fundamental) they use to screen for eligible candidates, but invariably the number of candidates will exceed what can be managed with available time and capital. I can remember spending many many hours in the evenings pouring over charts, looking at setups, and trying to decide which setup was better than another.
All other elements of a setup being equal, the final arbiter of stock selection should be volatility. Volatility will determine whether one stock is likely to move farther/faster than another over a given period of time. This is bang for the buck.
There are many ways to measure or calculate volatility, some more complicated than others. The most commonly used measures are Average True Range, Rate-of-Change, and Volatility.
Lets go back to our hypothetical trader with 20 eligible setups, but only enough capital available for 5 positions. The 20 setups should be ranked based on their volatility, and the 5 most volatile stocks should be selected. These stocks will be more likely to produce larger gains (or losses) than their brethren.
This one simple addition to a trader’s toolbox will save time through simplification of the selection process, and assuming one is in possession of a positive expectancy strategy, will increase returns.
One of the few “sure” think in financial markets is volatility mean reversion…short-term volatility is mean reverting toward a longer-term one. Having said that, wouldn’t it be better to do just the opposite? Selecting the names with the lowest short-term volatility compared to a longer one since we should expect that volatility to increase going forward.
paolo
Greetings Paolo.
I agree that volatility is mean-reverting, but let me remark on why I think selecting stocks which are already exhibiting higher volatility is better than ones that are exhibiting low volatility.
1. Most of the readers here operate in shorter time frames, as do I. Typically, if a stock is already exhibiting higher volatility, we operate on a short enough time frame where this volatility will persist.
2. The converse of #1 is that operating on a short time frame means that if we are often not in a trade long enough for low volatility to mean-revert to high volatility, while still in the trade.
3. In order to trade volatility as you have mentioned, which would be to buy the lowest short term volatility and expect it to increase it going forward, we would have to identify a specific set of conditions which would forecast a volatility expansion. That is not the point of this article. The idea is to take a setup, and use volatility to rank the stocks. This is quite different from building a setup around volatility itself.
4. Even over longer time frames, such as those who trade on fundamentals might use, volatility will persist. However, I can agree that it would be interesting to i. identify a fundamental setup, ii. calculate the long-term volatility, maybe looking back a year, iii. calculate the short term volatility, maybe 30 days, iv. and then select the stocks which have historically high long term volatility but over the short term, the volatility has dropped significantly.
Good comment Paolo!
That portfolio allocation issue has been nagging for me for a while.
I am into building a long-term trend following system (using futures) and that issue of what instrument to allocate to is a big question to solve yet.
For me volatility does not do it though because most stops are based on volatility also (ie 2 ATR): so a lower volatility (low ATR) will result in a lower absolute gain. But if you adopt a position sizing where, for example, the risk (implied by the stop-loss level) on each trade is X% of equity, the lower the ATR, the larger the position (and therefore the higher the absolute gain). Which overall makes the volatility at the beginning of the trade irrelevant (only the ratio R of trade return vs. initial risk will drive more or less gain – but how do you predict it?…)
Also, what I have been reading (from CTAs, etc.) is that they take volatility into account but they seem to be more in favour of (probably because high volatility correlates with higher overall correlation…)
Other strategies I have come accross that might be worth investigating are the choppiness index (from Bill Dreiss) or Welles Wilder’s Directional Movement Indicator as a way to rank instruments – any opinions on those?
Jez, good point about position-sizing with ATR stops. You’re right that this for the most part will negate some of the benefits of ranking stocks based on their volatility. One consideration may be to have to lookback periods for volatility- 252 days and maybe 30 days. Take the ratio of the 252 day:30 day volatility. I think this will find stocks that have BEEN volatile over the past year, but have recently been quiet. I haven’t tested this, but I’m curious to see if this won’t find stocks that are more likely to soon see a resumption of volatility.
I have not checked out the choppiness index or Welles Directional Movement Indicator, but I will.
Thanks Jez.
Jez, thanks for stopping by.
You’ve asked some interesting questions. As I get time today, I’m going to stop back by and drop off some thoughts on the issues you presented.
Jez, I believe I agree with your premise that volatility is irrelevant in that sense, if you base your stop and position size on the volatility (as I do). The reason volatility is important to me (I use a system very similar to Wood’s currently) is for this reason: more trades. Like Wood, all else being equal, I will take the one with the higher volatility. Higher volatility means a smaller position size for me and lower volatility means a larger positions size; the trade expectation (edge) is the same for either trade because of my position sizing. Where it makes a difference is that since the position sizes are smaller for the more volatile issues, I can take on more trades for the same expected outcome. Higher volatility = more trades I can put on = more “expected gains” = higher total return.
Junk, excellent point, re: higher volatility meaning that you will be able to take on more positions due to your position sizing formula making smaller positions. Thanks for sharing that.
Expectancy*Opportunity=Profits
I guess it depends on your portfolio risk management system:
For example if you have a rule that says that every position will risk 1% of your equity with a maximum portfolio heat of 10%, you are limiting yourself to 10 positions (regardless of position size).
I am looking at this through the “prism” of futures trading on margin and I can see that the above is actually conditional to having enough capital (margin for futures) to open these 10 positions. Obviously if an instrument has such an extremely low volatility that the position size is very large, it migh “eat up” a large part of the capital available and reduce the capital available for other potential positions. So your point is very relevant!
The concept applies to stocks equally I believe.
Thanks for the input and discussion which triggered an interesting reflexion..
I think the above calls for volatility-adjusted margin requirements from the exchanges 😉
This is an interesting situation I find myself in because I disagree with you.
Volatility is the standard deviation of (price – moving average of n period) squared.
What this means to me is that you’re advocating putting your capital in a higher risk situation which is fine if, all things being equal, your expectancy is the same for periods of higher volatility as with lower volatility.
But, I would wager most systems have significantly different expectancies depending on the associated volatility for said period.
Ideally, one wants a system that generates consistent revenue with lower volatility because that means that less capital is at risk per trade.
Cuervo, the proper regime can be determined, but it is about more than just volatility. You also need a measure of trend.