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Technical Analysis

Volatility as the Basis of an Advanced Investment Approach

by Patrick Oberhaensli, on Jun 8, 2020 4:46:00 PM

In this article, we will address the danger of applying a long-only approach to US Equity Volatility – we already discussed the danger of a short-only approach. But it does not mean that there are no possibilities to develop a successful strategy that takes into account both long and short positions via futures… it’s the purpose of the discussion here.

Long-only Passive Approaches of US Equity Volatility

Clearly, we see that the return is very negative for a passive long-only exposure to volatility. This approach would inevitably have led to a maximum drawdown equivalent to a total loss. Moreover, the Sharpe Ratio would be very negative as not only the excess return is an issue but the volatility (of the volatility) is extreme as well. It actually resembles one of the profiles of the passive long-only natural gas exposure in which the Sharpe Ratio is -0.88. Therefore, it's recommended that if investors are drawing a parallel from another asset class, they should have a look at specific commodities.


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For the period starting end of March 2009 up to the 7th of February 2020, including specific costs, we have following for the US Equity Volatility long-only passive.

Characteristic

Measure

Compounded Annual Return

-55.90%

Yearly volatility

59.34%

Best month since 2012

+67.60% (August 2015)

Second best month since 2012

+44.08% (February 2018)

Third best month since 2012

+40.75% (October 2018)

Worst month since 2012

-31.57% (March 2012)

Maximum Drawdown

95 to 100%

Months with positive Return

26%

Beta

1

Sharpe Ratio (with 1.50% risk-free)

-0.97

 

It should be noted that an investor with exceptional timing skill could have captured the set of best monthly returns that together represent very substantial gains. But they are quite “isolated” from each other.

Now, let’s have a look at a long/short active strategy for the very same market… The only element which apparently does not improve is actually the… volatility. That is not a big surprise as the volatility is a bad risk measure in the context of non-Normal distribution of the returns.


The Really Active Risk-based Approach of Equity Volatility

When considering a radically different approach to deal with the dynamic volatility regimes, we could establish the following negative beta profile:

For the period starting end of March 2009 up to the 7th of February 2020, including specific costs, we have following for the US Equity Volatility USD long/short negative beta

Characteristic

Measure

Compounded Annual Return

34.56%

Yearly volatility

66.23%

Best month since 2012

+84.52% (February 2018)

Second best month since 2012

+55.42% (June 2016)

Third best month since 2012

+41.97% (July 2012)

Worst month since 2012

-32.04% (May 2019)

Maximum Drawdown

65 to 70%

Months with positive Return

58%

Beta

-0.28

Sharpe Ratio (with 1.50% risk-free)

0.50

 

The negative beta is consistent with the idea that being only long volatility, destroys value. Nevertheless, it is also about capturing – at least in part - the main high-volatility-regimes that can appear quite quickly. And may not last for long: one should not forget the mean-reversion effect. That, moreover shows the high diversification effect with equities in particular.

The main reason is because the risk inputs also come from the traditional markets – which allows a dynamical approach that is based on less efficient indicators and parameters.

The long-term average return is in a proper relationship to the level of risk; risk that can easily be adjusted given that the implementation takes place with futures. One possibility would be to reduce the maximum drawdown to the level of US large cap equities – that’s about 15 percentage points less – by simply re-calibrating the number of futures.


Conclusion

A long/short strategy based on the US equity volatility is one practical way to potentially generate alpha and allow to further diversify a portfolio. And a risk-based approach would add significant value. For sure, a long-only passive approach is totally useless but long volatility futures could be used for momentary hedging purposes.


EVOLIDS FINANCE LLC, Disclaimer:

• This content is not intended to be a solicitation nor an offer
• The preparation of the information provided herein is done with a high level of care. Nevertheless, errors are possible

 

Topic:DiversificationAnalysis and StrategyUS Stock MarketNYSEFuturesVolatility
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