Volatility is a very commonly used concept among traders when it comes to describing risk and the risk and profitability of a trading strategy. But volatility is not always the best suited metric to choose when it comes to evaluating the performance of a trading strategy, and it may even lead to wrong and dangerous assumptions and implications.
What is the volatility of a trading strategy?
When talking about the volatility of a trading strategy, it describes the relative size of losses and gains, compared to the average gain or loss. A low volatility trading strategy would, therefore, be a steadily performing system without major outliers – but it doesn’t say anything about whether it is a potentially winning or losing trading strategy. On the other hand, a trading strategy with a high volatility has significant swings in the development of the account equity, both positive and negative.[bctt tweet=”Are Volatile Trading Strategies Riskier Than Low Volatility Strategies? #tradingstrategy”]
Volatility vs. Risk – two completely different things
As indicated, volatility does not describe the risk and the profitability of a trading system because it only refers to the relative size of losses and gains, not about the actual performance.
In an earlier article, we have discussed the limitations of evaluating trading systems based on the percentage performance. Volatility is also of only limited use and misinterpreting this metric may lead to wrong assumptions about a trading strategy and the potential outlook, with potentially disastrous consequences.
Where does your strategy fit in? The 4 potential scenarios
Whether it is choosing an automated trading strategy that you want to follow or building your own trading methodology, understanding and defining the risk parameters and finding a methodology that fits your personal level of risk-tolerance is of great importance for long-lasting success. When it comes to describing trading methodologies in terms of volatility and risk, there are 4 potential scenarios.
Disclaimer: Regardless of any assumptions, There is a substantial risk of loss in futures trading. Past performance is not indicative of future results. Futures trading involves significant leverage and may lead to large gains or large losses beyond the principle invested.
#1 Low volatility and high risk
This combination is particularly dangerous because it usually describes trading systems that have performed well in the past and have not been exposed to adverse and changing market conditions. For example, in a long-lasting bull market a trader buys every dip and even when the trade goes against him, he adds to a losing position to bring down the average price. This strategy may work well in a strong trending bull market, but once market conditions change and a shift from a bull to a bear market happens, a trader may continue to add to a losing position until he wipes out all of his trading account with one trade.
Another example of a low volatility, high risk trading strategy would be selling out of the money options. Such a system may have long periods of small winners by collecting the fees from the option buyer, but one trade that goes against him may threaten his whole trading account because of the unlimited loss potential when being the seller of options.
#2 Low volatility and low risk
Such a trading strategy is defined by a strict and disciplined risk and position sizing approach. For example, a trader always chooses to risk 1% of his total account on any given trade and his potential profit is 1.5%. Furthermore, we assume that he does not violate risk management principles such as widening stop loss orders or taking off stops completely. The outcome of all his trades may look very similar and low volatility and low risk may indeed exist in such an environment.
Risk describes the occurrence, or the possibility, of encountering relatively large losses which may impose significant threats to a trading account. A low risk trading methodology, therefore, is less likely to experience such losses and account development is rather steady.
#3 High volatility and high risk
This combination is often how trading strategies of inexperienced traders and traders who are looking for “a quick buck” are characterized.
The high risk aspect comes from potential large losses which are mainly caused by mismanaging risk and giving in to impulsive trading decisions. As mentioned earlier, not trading with a stop loss, widening stop loss orders, adding to a losing position, revenge-trading or over-trading are all things which expose a trader to great risk and potentially large losses.
The high volatility of such trading is described by the large account swings such traders are likely to experience. When taking positions that are relatively large, compared to the overall account size, and undisciplined and impulsive trading come together, the account development may experience large swings and great ups and downs.
# 4 High volatility and low risk
A trading methodology with such risk and volatility parameters is the opposite of the first one and we can describe this scenario by explaining the position of the trader that takes the opposite side of the trade of trader #1.
A trader who cuts his losses very fast and operates with tight stops may be stopped out frequently and may also have periods of relatively long, but consistent, losing streaks. However, his goal is to capitalize on the few big winning trades and ride them for as long as possible.
The buyer of out of the money options has a similar risk profile. He pays the premium for the options and most of the times he will not be able to exercise the option and has to take a loss. But, due to the unlimited profit potential as an option buyer, only a few winning trades may offset past losses rather quickly.
Conclusion: Due your due diligence and find what suits your personality
Before following a trading strategy, it is indispensable to thoroughly evaluate the risk parameters to reveal potential deficiencies of a trading strategy. Even a seemingly well performing trading strategy could expose the trader to significant risks.
Furthermore, even a trading strategy with low risk and high volatility may not be suited for all traders because of the emotional challenges that come with enduring long losing streaks and still being able to perform at a high level. It is therefore important to audit yourself and see which type of risk is suited based on your personality.
Trading futures and options involves substantial risk of loss and is not suitable for all investors. Past performance is not necessarily indicative of future results. The risk of loss in trading commodity interests can be substantial. You should therefore carefully consider whether such trading is suitable for you in light of your financial condition. The placement of contingent orders by you or broker, or trading advisor, such as a “stop-loss” or “stop-limit” order, will not necessarily limit your losses to the intended amounts, since market conditions may make it impossible to execute such orders.