Reducing Volatility: When less is more....
July 26, 2004
With recent news on the US economy, Iraq, and corporate profits sending stock markets, interest rates, and energy markets moving wildly; several trading system investors are feeling the increased volatility in their own portfolios in the form of quick, drastic losses in equity.
These quick losses represent high levels of volatility, or risk, in these accounts. While many investors accept such risks as part of this type of investment, hoping that the risk are offset by commensurate oversized returns, there is a case when less is more. More simply put, reducing this volatility, making it LESS, can lead to higher (MORE) returns per unit of risk. But how dies an investor go about insuring that less is more? Let's first review why the variance in returns, or volatility, equals the riskiness of an investment.
While two investors who both lose 30% of their account value may be viewed similarly, the investor who suffers the loss in just one week has much higher volatility, and risk, than the investor who lost the same amount over several months. The end result may be the same, but the investor who feels the pain of losses quickly fears it may continue at the same pace, quickly taking her account severely lower.
It is this variance in returns which worries most investors. The investor who loses no more than 2% in a month knows she has many losing months before losing all of her capital. The investor who sees a monthly variance of 20%, however, knows she may lose all of her capital within a few short months.
The most common form of risk is variance, measured most often by Standard Deviation. The standard deviation is a statistic that illustrates how closely all the various points of data are clustered around the mean in a sample of data. When the examples are pretty tightly bunched together and the bell-shaped curve is steep, the standard deviation is small. When the examples are spread apart and the bell -shaped curve is relatively flat, that tells you have a relatively large standard deviation.
In relation to trading system returns, a high Standard Deviation of monthly returns is telling you that you can expect a wide range of returns, from down 30% to UP 70% and several points in between. Conversely, low Standard Deviation values occur when returns are consistently stable. The measure of Standard Deviation is most often referred to as the Volatility of the investment. Investors relate volatility with risk, as a high level of volatility implies that at any one point the investor could be experiencing the 30% DOWN period or the 70% UP period from the above example. This uncertainty of what the returns will be in the next period is why Standard deviation is used as a measure of risk.
Staying with the above example, many investors would rather sacrifice the 70% return if it meant they could also eliminate the chance of a 30% loss. In a trading system where there is a lower volatility of returns, many of the extreme points have been removed, meaning a lower standard deviation, smoother equity curve, and more consistent results.
Armed with this measure of risk, all the investor needs to do is find the investment with the lowest possible standard deviation, correct? NO. A standard deviation of ZERO can be achieved with a trading system losing 15% every month, or by a system making 100% each month. Remember, it is the variance in the monthly returns, not the returns themselves.
But reducing volatility is a key element in reducing risk. How can an investor reduce the volatility in her portfolio? The answer, as always, is diversification. Investors diversifying across several systems can reduce volatility while potentially keeping returns the same, if not better.
The graph below depicts the volatility of monthly returns in three different portfolios. The first, containing just the Helix SP system, the second containing Helix and the Tzar system trading both the ES and NQ, and the third containing Helix, Tzar ES & NQ, and the Andromeda Mid Size portfolio. The first portfolio was tested with the developer's recommended initial equity of $75,000. Each subsequent portfolio was tested with just 50% of the developer's recommended initial equity, showing how a portfolio of systems can "share" equity in a sense, making full capitalization unnecessary.
It is interesting to note that the annualized standard deviation of the portfolios listed below would be 58%, 44%, and 32% respectively. These are big numbers when compared to the 14.2% annualized standard deviation of the stock market as represented by the S&P 500, and explains some of the high risk stigma associated with futures investments.
As the chart shows, the volatility of monthly returns falls as each new system is added, without affecting the average annualized return too much. The Sharpe ratio, a risk/return ratio which weighs returns against risk in the form of standard deviation, also climbs as each portfolio is diversified to other systems. A higher Sharpe ratio implies a safer strategy at least in terms of the variance in returns, and we can see that the volatility in each portfolio does indeed drop.
The lesson here, as it often is, is to diversify. The investment of more money across more strategies greatly reduces volatility, and reduced volatility equals reduced risk. The lesson between the lines is that age old morsel of wisdom: "It takes money to make money." This is a tough lesson to learn for several investors wanting to "test the waters" before fully investing in alternative investments, but it is a valuable one.
IMPORTANT RISK DISCLOSURE
Futures based investments are often complex and can
carry the risk of substantial losses. They are intended for sophisticated investors and are not suitable for
everyone. The ability to withstand losses and to adhere to a particular trading program in spite of trading
losses are material points which can adversely affect investor returns.
Feature | Week In Review | Chart of the Week |
Feature | Week In Review | Chart of the Week |
Except where noted, the below Profits/Losses based on closed out trades. $50 per R/T commission included ($30 per emini) Percentage gains based on developer recommended initial balances as listed at www.attainaccess.com.
The U.S. Stock markets sprung back to life last week with Alan Greenspan’s testimony on Capitol Hill, earnings from 117 members of the SP 500, and a record dividend payment by Microsoft providing traders with plenty to trade on. Unfortunately for the bulls most of the market action was downward with SP 500 futures falling -1.6% and Nasdaq futures falling -1.70% for the week. Microsoft’s announcement on Tuesday provided brief respite for the bulls but it was only temporary as modest earnings dominated market sentiment.
Several trading systems benefited from the down move, perhaps none more so than I-Master and Tzar, which both reversed short on Thursday morning and caught the entire sell off. Day trading performance was mixed with a several systems taking profits and others taking losses. The long term markets continue to be choppy and difficult to trade. Cotton and Corn, two markets that have trended well, continued to move lower last week as Cotton fell -1.4% and Corn dropped -0.5%.
**Day Trading**
Despite the increased trading range and market volatility in the SP market it was a relatively quiet week for day trading systems. Compass SP was one system that had an impact after making a total of +$1710.00 per contract on two trades. Compass received a little extra push from the Microsoft announcement that rallied the markets late on Tuesday. The system almost sold the market’s highs and took profits of +$2162.50 per contract on a long position. Proving once again that for the most successful systems it is not where the system gets in a trade but rather where the system exits a trade that matters most.
Compass was not the only system to benefit from last weeks market movement. Daybreaker SP took profits of +$935.00 per contract as the system tries to rebound out of drawdown. Magnitude SP picked a great week to begin trading at Attain making +$1325.00 per contract after trading three times.
BWT Zones 3.0 (+$275 per contract), BWT Zones 2.1(+$150.00 per contract), and AG-Xtreme SP (-$50.00 per contract) all closed the week near breakeven. R-Mesa 5 SPand Helix SP both had forgettable weeks with R-Mesa SP losing -$1162.50 per contract and Helix SP losing -$4532.50 per contract.
Finally, RC Success and Impetus e-RL ruled the e-mini markets with RC Success making +$890.00 per e-mini SP contract and Impetus e-RL making +$772.50 per e-mini Russell contract.
Before reversing short on Thursday both I-Master and Tzar were able to earn small profits on long positions. I-master took profits of +$52.50 per contract in the ES, I-master e-MD made +$260.00 per contract, and I-master e-RL made +$380.00 per contract. I-master NQ was not as fortunate losing -$700.00 per contract. Tzar ES made +$470.00 per contract on the short reversal but lost -$250.00 per contract in the NQ. Axiom SP , meanwhile, completed its first week of trading at Attain and lost -$1825.00 per contract on two trades.
**Long Term**
Compared to the U.S. stock markets it was mostly a quiet week for multi-commodity traders. The U.S. Bond market remains range bound and may remain so until the next round of interest rate decisions. Foreign currencies were the exception as they sold off late in the week, with Eurocurrency falling -2.50% and the Swiss Franc falling -2.95% to stop several systems out of long currency positions. Trendchannel was stopped out of the Eurocurrency for a loss of -$2537.50 per contract, as was Andromeda which lost -$2725.00 per contract. Checkmate and Andromeda were stopped out in the Swiss Franc with Checkmate losing -$1525.00 per contract and Andromeda losing -$2162.50 per contract.
System profits continue to increase in the grains and cotton as growing conditions have been superb this summer. Systems with short grain conditions include Andromeda which is short in the corn (+2175.00 per contract) and KC Wheat (+$1150.00 per contract), Brix is short in the CBOT wheat for open trade profits of +$1487.50, and Aberration which is short in the corn for open trade profits of +$1600.00 per contract.
Please Login to: http://www.attainaccess.com for the latest updated statistics.
IMPORTANT RISK DISCLOSURE
Futures based investments are often complex and can
carry the risk of substantial losses. They are intended for sophisticated investors and are not suitable for
everyone. The ability to withstand losses and to adhere to a particular trading program in spite of trading
losses are material points which can adversely affect investor returns.