Are You Rewarded for Taking More Risk?

No, you’re not. Of course there are some exceptions, but let’s consider how the institutional managers handle the problem before we look at some examples.

Unless you know that a specific trade is going to give you a bigger profit than others, you want to be sure that every trade you enter has the same risk. That gives each trade an equal chance to participate in the returns. If you put more risk on (a larger position exposure) then that trade had better give you a proportionately bigger return; otherwise, you have just increased your risk for no reason. Normally, when you size a stock position by allocating equal dollars to each stock and dividing by the entry price, you are more-or-less assigning equal risk. So when prices are high you have a smaller number of shares and when it’s low you have more shares. That’s straight-forward and works.

What happens when the price of your stock spikes? How big is a spike? Let’s look at two examples below. First we need to create a trading system so that we know if high or low volatility translates into profits. We choose a simple 60-day moving average, long only, because this is the fastest period we think of as a “macro-trend” concept, which we know has performed well for many years. On the left is United Health Care (UNH) and on the right the NASDAQ ETF (QQQ). The total return is shown in blue and the annualized 20-day historic volatility (the same time period used for options) is in red.

For UNH the volatility spike in 2008 corresponds to the largest drawdown. Volatility exceeds 100% because it’s based on only 20 days and extrapolated to a full year. That’s the way it’s done. There are also smaller spikes. The one in 2002 doesn’t generate a loss but the one in 2011 does.

QQQ is a bit different. The volatility of an index will always be less than an individual stock, but the very high volatility in 1999 to 2000 coincides with the major top in NASDAQ. It also has a peak in 2008 and again in 2011, all of which corresponds to losing periods. But even of you managed to get out with a profit, you would have been exposed to extreme risk. The reward is not worth the risk.

What is the right volatility to exit a trade? Each stock has its own volatility profile, but in general, the place to exit is the average volatility plus 1.5 standard deviations of the volatility. That isolates about 5% of the upside extreme. For UNH the average is 26% and the standard deviation is 16%, so 26+1.5×16 = 52% volatility. If you look at the 52% level on the chart above, it captures part of the smaller spikes and most of 2008. Even with the higher volatility in QQQ during 1999 to 2000, the key volatility level is about 50%.

These numbers don’t always give the ideal place to exit, but a good guideline and a good way to control your risk. It’s better to be out of the market during high-volatility periods.

We can also look at low volatility as an opportunity. In both examples, we see that periods of low volatility seem to work well with the trend system. In professional portfolio management, they try to target a constant volatility, so when volatility declines they leverage up the position (usually the entire portfolio equally). It turns out that avoiding high risk and favoring low risk is the winning strategy. How could that be a surprise to anyone?