Using volatility to create trading systems.
Introduction – About volatility:
When we talk about Financial Markets, probably volatility is a term that a retail trader won’t think about. But if we want to create good trading systems is something that we need to account for.
Volatility is the measure of how fast and how far the markets move, often for the worse (Financial indexes). This means, the higher the volatility, the higher is the dispersion of returns.
As we can see in the chart above, we have the volatility in the Standard & Poors’ 500 Index, better known as S&P 500, one of the biggest financial indexes in the American market.
We can see the volatility returns change over time, and with each change we face a different market regime, in this article i want to show you the basics about trading volatility using data in different markets such as Forex and Futures using the same method that i use to trade in my account with a portfolio of trading systems (more info).
Returns and correlations:
We can use hundreds of different approaches when we talk about volatility, i’m going to keep this simple. Let’s see a picture:
This is a density chart, it shows us the percent return of a certain asset each day and the number of incidences, as you can see, the usual is having small returns on both sides. But certain times, volatility acts and everything changes. If you see the chart and look for details, you can guess that most of the times that volatility increases so does the returns, sometimes with higher returns but most of the time with negative ones.
The negative tail is bigger than the positive tail.
Something similar happens to some forex pairs, the ones that are correlated with risk-on and risk-off situations:
As i was saying, in a normal situation we have the most common days, volatility is low and usually a trend is consistent.
In the case of Forex, as we are going to see later, we will need to classify volatility later, usually Forex tend to be less volatile but also doesn’t have a predefined trend unlike financial indexes.
What happens when volatility increases?
We can check that with correlation measures, between volatility and returns. And even autocorrelation to check if there’s some between the current value and past ones.
Is there any correlation between the increment of volatility and the obtained returns? Here is the first test.
First of all we are going to eliminate any trend and price.
This first test is very interesting, since the correlation seems to be very low but when volatility tends to be high, the returns on the electronic session (US Market hours) tend to be negative.
So, I’m going to complicate things a little more. Right now we know that, the higher the volatility in the market, returns tend to go to the fat tails of the distribution or density.
But, we only know this when it has already happened, and i’m not talking about trading this, yet. If volatility today is higher than usual, what will happen tomorrow? That’s the question, and for this, we can measure anything using Auto-correlation to see if any current event has an impact on the future.
As we can see, the current volatility has a correlation with past events.
Knowing that, we can extract the next hypothesis: If yesterday’s volatility is greater then X, what will happen today?
Creating a trading system:
Using the given hypothesis we can create interesting trading systems based on facts and statistics instead thanks to the use of data.
As we know, trading or investing out of the Electronic Trading Hours (ETH) beats the overall return of the index. Given the fact, that, if most of the Index returns’ are given out of the American Session, most of the bearish returns happens at the ETH.
Then, we are going to test what happens when yesterday’s volatility is higher than a certain trigger to see what happens the next day:
As we can see, the greater the volatility, the greater is the risk and lower the premium we collect Trading.
And while the vol is lower, the risk is significantly lower:
Then, our trading system will consist in being long in Indexes while volatility is low and exit the market if volatility increases above a certain trigger.
This is a very underrated method of analysis (all quantitative trading in general terms), “low vol” tends to underperform passive investing but the risk is way lower and we can add this strategy to a diversified portfolio to have exposure to different markets.
We can apply the same procedures to Forex or any other markets if we classify the volatility (sell-off or bullish).
As always, hope this can help you improve your trading.
Victor – Follow the Edge.
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