Targeted Volatility Analysis
One of the most overlooked areas in trading is the focus on keeping a constant bet size in order to ensure consistent risk-adjusted returns. Most traders fail to explicitly adjust for market volatility, which can have a catastrophic impact when you have the misfortune of betting the wrong way when the market is swinging violently. The use of leverage makes this even more dangerous. However this factor affects the buy and hold investor as well. Portfolio management is predicated on creating an asset allocation for investors that have a certain risk/return profile based on expected returns and volatility. Most passive portfolios keep constant exposure to market conditions, leaving them effectively overleveraged when volatility spikes in years like 2008.
So how do portfolio managers in the field deal with such issues? A friend of this blog, Jerry Wagner has a great deal of experience making these types of decisions as the president of Flexible Plan Investments. CSS was recently in attendance at the NAAIM Uncommon Knowledge 2010 Conference in Orlando where Jerry presented an interesting technique for position sizing/hedging using current and historic volatility. This is the first in a two part follow-up to the Secret Sauce Trading Seminar at in which one of our CSS researchers—David Abrams—also presented a paper. So what is Jerry’s secret sauce to address the issue of maintaining constant volatility for a portfolio? The equation is really very simple yet mathematically elegant:
You can incorporate this into your own trading with or without leverage. Here’s how to do it with leverage:
If (HR < 1) Position Size = 1 – HR
If (HR >1 and HR<2) Position Size= HR
If (HR> 2) Position Size = 2
Position size of 1 means full position, 2 means 100% leverage. So a hedge ratio (HR>1 and HR<2) means leverage of (HR-1). This has the benefit of continuously adjusting position size based on the ratio of the historic volatility to the current volatility. The numerator can be adjusted by a volatility multiplier to “target” a specified level of volatility and make your system more conservative or aggressive.
Let’s look at an example.
|CAGR||St Dev (daily)||Sharpe||DVR||MaxDD|
|TVA (no leverage)||6.55%||0.84%||49.14%||0.02%||-34.09%|
|TVA (200% leverage)||7.59%||0.79%||60.35%||0.05%||-30.58%|
In the graph below you can see how a simple long only strategy using TVA and leverage to control position size can reduce the max drawdown in half and almost double the Sharpe ratio while also slightly increasing the CAGR.
The resulting equity curves are much more stable than a buy and hold allocation despite using leverage explicitly. In future posts we will look at how to incorporate volatility and other metrics into position sizing. These will be incorporated into our portfolio management tools for systems. Good work Jerry!