Navigating Market Risk with Volatility Targeting

Volatility targeting is a trading strategy that adjusts the position size based on market volatility, aiming to optimise risk and returns by increasing the position size during calm periods and reducing it during volatile ones. We tested out this strategy on SPY ETF for the period starting 2005 to 2021 and these were the results:

 

	Strategy Performance	Drawdown	Return-to-Max. Drawdown
Volatility Targeting	6.62%	-11.62%	0.57
Benchmark	7.19%	-18.72%	0.38

 

Although the strategy returns are not as good as the benchmark returns, the maximum drawdown is significantly lower which in turn improves the overall return-to-maximum drawdown. It is important to note that backtesting results do not guarantee future performance. The presented strategy results are intended solely for educational purposes and should not be interpreted as investment advice. A comprehensive evaluation of the strategy across multiple parameters is necessary to assess its effectiveness.

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All the concepts covered in this post are taken from Section 9 Unit 1 of the Quantra course on Position Sizing in Trading. You can preview the concepts taught in this course by clicking on the free preview button.

Note: The links in this tutorial will be accessible only after logging into quantra.quantinsti.com

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Understanding Volatility Targeting

Before we dive into the details, it's crucial to understand that volatility targeting isn't about supercharging your returns. In fact, it may slightly reduce your performance. So, why bother, you ask? Well, because the market is anything but steady; it has its ups and downs, especially when it comes to volatility.

 

You see, market volatility tends to cluster. High volatility periods are often followed by more high volatility, while low volatility begets additional calm periods. In this ever-changing landscape, volatility targeting becomes your ally by helping you time your leverage ratio just right. And when you do that, you can potentially increase your overall return-to-maximum drawdown ratio.

 

But, of course, like any good trader, you'll want to put this to the test. That's where backtesting comes in.

 

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Understanding the Market's Behaviour

Let's run a backtest on the volatility targeting technique, using the index reversal strategy as our canvas. But before we jump in, we need to understand the underlying market's behaviour.

 

Market volatility is like a rollercoaster ride. It's not a smooth sail. Periods of high volatility alternate with serene moments of low volatility. We measure this daily volatility by calculating the standard deviation of the past 20-day returns. On average, it's about 0.99%. But then we also have days when it's as low as 0.5% and days when it skyrockets to 2%, 3%, or even 4%.

 

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Volatility Targeting in Action

Now, let's get to the exciting part – volatility targeting in action. This part is all about adjusting the leverage ratio or the size of your positions in accordance with volatility. If the volatility is high we reduce the leverage ratio, if it is low, we increase the leverage ratio.

 

Here's how it works:

If the average 20-day volatility decreases compared to the previous day, we increase our leverage proportionally. Essentially, we're dialling up our trading power when things are calm.

 

• If, for instance, the past volatility is 0.75%, we apply leverage calculated as 1% divided by 0.75%, which equals 1.33 in this case. This means they use 1.33 times the capital they have for trading.
• Conversely,when past volatility is high, like 3%, decrease the leverage. Again, the leverage is calculated as 1% divided by 3%, which equals 0.33. In this case, we only use 33% of our capital for trading.
• The maximum leverage limit is set at 2, which means we won't use more than twice our capital for trading, even if the calculated leverage exceeds 2.

 

In essence, this approach ensures that when the market is calmer (low volatility), we use more leverage, and when it's more turbulent (high volatility), we reduce our leverage to minimise risk. The maximum leverage is capped at 2 to avoid excessive risk-taking.

 

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The Results 

So, how does this affect our trading strategy? Well, the returns might be a tad smaller, but the drawdowns? Significantly smaller! The return-to-maximum drawdown ratio shoots up, far surpassing our benchmark strategy.

 

	Strategy Performance	Drawdown	Return-to-Max. Drawdown
Volatility Targeting	6.62%	-11.62%	0.57
Benchmark	7.19%	-18.72%	0.38

Taking a closer look at the leverage ratio over time, we see it fell to around 0.2 during the global financial crisis in 2008 and 2009. On the flip side, during peaceful economic times in 2006, 2014, 2015, 2017, or 2019, it soared to 2.0. All in all, it's a dynamic dance that adapts to the underlying market risk.

 

And there you have it, a glimpse into the world of volatility targeting. It's not about hitting the jackpot with every trade; it's about navigating the waves with precision. Volatility targeting lets you harness the market's rhythm and make the most of your trading strategy. It is important to note that backtesting results do not guarantee future performance. The presented strategy results are intended solely for educational purposes and should not be interpreted as investment advice. A comprehensive evaluation of the strategy across multiple parameters is necessary to assess its effectiveness.

 

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What’s more? Automation!

You can completely automate your trading strategy to trade for you based on the model using Blueshift.

 

It is included in the course and we also have a free short course on Automating Trading strategies. Tailored ready-made strategies are also provided in the course for you to implement and experiment with, using Python. But be sure to backtest your strategy and implement risk management first since trading is always involved with risks and it wouldn’t be wise to blindly jump in without any precautionary measures.

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What to do next? 

 

• Go to this course 
• Click on
• Go through 10-15% of course content 
• Drop us your comments and queries on the community 

 

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IMPORTANT DISCLAIMER: This post is for educational purposes only and is not a solicitation or recommendation to buy or sell any securities. Investing in financial markets involves risks and you should seek the advice of a licensed financial advisor before making any investment decisions. Your investment decisions are solely your responsibility. The information provided is based on publicly available data and our own analysis, and we do not guarantee its accuracy or completeness. By no means is this communication sent as the licensed equity analysts or financial advisors and it should not be construed as professional advice or a recommendation to buy or sell any securities or any other kind of asset.