Most trading system developers and traders develop trading strategies based on market volatility constraints. Their strategies/systems are designed to operate within certain market volatility levels, notes technical specialist Chris Vermeulen, editor of The Technical Traders.
If the markets enter periods of excessive volatility, their strategies may result in excessive risks/losses for periods of time.
Many system developers attempt to develop quantitative features to adapt their strategies to changing volatility levels. Often adjusting entry sizes, stop levels, target levels, and other internal elements to address the increased trading risks through extreme volatility events. Yet, even these processes have limits in what they can accomplish.
Increased Market Volatility Creates Havoc & Extreme Risks for Most Strategies
Excessive volatility can create vast amounts of risks and potentially destroy the ROI of a trading strategy quite quickly. This can make it almost impossible for a trader to adapt their strategy to higher volatility while attempting to mitigate the extreme risk levels associated with extreme volatility. Today, we will explore ways to help traders adjust to the huge increases in market volatility that will continue into 2022 and beyond.
Current US market volatility is more than five times the volatility level in 2016~2017. This Weekly S&P500 Volitility Index (VIX) chart highlights the increasing Normal Range and Upper Threshold for VIX over the past four years. The Average VIX range has increased from 8.0 to 12.0 in late 2017 to over 18.0 to 25.0. This reflects a two to three times increase from the lower VIX ranges over the past decade.
There was a time when VIX above 10.0 or 11.0 was considered large volatility. Now, those same levels would be regarded as very moderate volatility. Large volatility is now when the VIX is above 16.0 to 18.0. Excessive volatility happens when the VIX moves above 19.0 to 21.0.
The post-Covid market volatility levels may have created a very dangerous market environment for system/strategy traders. Unless traders were prepared for this increased market volatility or were able to quickly adapt their strategies over the past 12+ months, the end of 2021 may have destroyed returns for system traders. The big market price rotations throughout the last six plus months of 2021 have been challenging for some systems.
Average True Range Clearly Shows Volatility Increases Recently
This Weekly S&P 500 ETF Trust (SPY) chart highlights the increased market price volatility over the past eight plus years. Notice how the peaks in ATR occur during market corrections/pullbacks. This is because market volatility typically increases quickly in downtrends/pullbacks and then settles in moderate uptrends.
The peaks for ATR on this SPY chart occurred on these dates:
June 2010: 5.01
December 2011: 6.35
February 2016: 7.14
April 2018: 8.05
December 2018: 10.55
April 2020: 18.80
If the US/global markets were to roll over sometime in 2022, possibly because of the new Omicron virus or other global market events, could we see ATR spike to levels above 18.80? What would that look like for the global markets? Would your trading system/strategy be able to handle that type of event? Are you prepared for a huge volatility spike?
Adapting To Market Volatility Efficiently
Unless your strategy can adapt to increasing volatility efficiently, there is one simple rule that you can deploy to help you preserve capital as you continue to trade your system through volatility spikes. I call it the Capital Allocation Threshold process.
It is simple to use and deploy while it creates a very efficient “move to cash” process to avoid excessive risks in a naturally progressing process. Ideally, you would set draw-down thresholds from the highest equity peaks of your system as hard equity decrease levels if volatility spikes adversely affect your trading strategy.
The Rules for This Capital Management System Are Simple
Track the highest peak of your system as it progresses forward.
- Whatever that level is, establish a set level of draw-down thresholds that act as a "hard process" of pulling capital away from your strategy if breached.
I suggest a 12%, 6%, 3% threshold to start with.
- You could also use a 10%, 5%, 2.5% threshold, but typical market rotations are generally in the range of 7.5% to 12% on average. The tighter you make the thresholds, the more likely you will see them reached in extreme volatility events.
Run a backtest/simulated run of your strategy to make decisions based on the Capital Allocation Threshold process.
- This way, when your strategy enters periods of increased returns, you'll be able to capitalize on them more efficiently while still executing efficient capital controls related to risks.
If your equity curve breaks below the first threshold, say 12%, then cut your trading allocation by 50%.
- If you were trading with $100k, you would cut all future trades to use only $50k.
If your equity curve breaks below the second threshold, say 6%, then cut your trading allocation, again, by 50%.
- If you were trading with $50k, you would cut all future trades to use only $25k.
If your equity curve breaks below the third threshold, say 3%, then cut your trading allocation, again, by 50%.
- If you were trading with $25k, you would cut all future trades to use only $12.5k.
If your equity curve breaks below the last threshold, the bottom of the 3% threshold, then stop trading your system altogether.
- Before you start allocating capital to your strategy again, wait for this pullback to exhaust itself and for your equity curve to recover back to anywhere within these thresholds.
Re-Allocating Equity As Your Strategy Recovers:
As your equity curve begins to recover and move higher, you would begin to deploy higher capital allocation levels as the equity curve moves up into the higher thresholds–eventually moving back to 100% full equity allocation. This way, you deploy more capital as your strategy continues to recover and move to new highs.
While executing this simple capital preservation strategy, you'll quickly understand how it is designed to protect capital while allowing your strategy to work through volatility and risk events. We are protecting 50% of your total trading capital at the first stage. We are protecting 75% of your total trading capital at the second stage. We are protecting 87.5% of your total trading capital at the third stage. Below that, we are protecting 100% of your remaining capital so you can learn to live through these risky volatility events and continue trading in the near future.
The Benefits Of Properly Balanced Trading Strategies Within Volatility Events
Suppose you have developed a strategy that seems to do well within these extreme volatility events. In that case, your strategy can likely adapt to the type of volatility we are currently experiencing.
I wanted to show you how volatility can improve your strategy results if you have properly balanced strategy risks and rewards. Let's take a look at two charts, Powershares QQQ trust (QQQ) & iShares 20-Year Bond (TLT), using the same strategy. The first is a one times QQQ/TLT strategy, and the second is a two times QQQ/TLT strategy. Notice how the recent market volatility, over the past five plus years, has dramatically improved the results of the two times QQQ/TLT strategy compared to the one times strategy.
This is the positive benefit of balancing risks within a strategy so your system can attempt to benefit from volatility events.
As you study these last two charts of the equity curves for a one times strategy vs a two times strategy, pay attention to how quickly the two times strategy could use the current market volatility to create gains much faster than pulling capital away from the markets. The only reason this strategy was capable of executing like this was that we developed advanced quantitative solutions that manage the balance between risks, volatility, and capital allocation.
Volatility can be a significant benefit for strategy/system traders. But it continues to present a struggle for strategy/system developers in managing risks. We hope our Capital Allocation Threshold example helps you overcome this issue and helps you learn to trade volatility more efficiently, while protecting your capital during critical market changes.