Building a Trading System: Part 5 – Volatility

In the past few posts we have built a very basic trading system, which we’ll attempt to refine.  While it’s profitable, one of the challenges we face is equity drawdowns.  In other words, I don’t really feel comfortable with the way my account balance is going up and down so much.  I’d like to further refine the system to find trades that will be profitable and avoid those that might cause significant drawdowns.

In this post, I want to introduce the concept of volatility in the market (or in an individual stock) and it’s effect on our trading system.  Volatility is simply a measure of how much the market, or the stock, is moving up and down. If I were to look at a chart of a volatile stock, it is normally very choppy.  Conversely, a stock with low volatility will have a very smooth line moving from left to right.  Investopedia described it this way:

“Volatility refers to the amount of uncertainty or risk about the size of changes in a security's value. A higher volatility means that a security's value can potentially be spread out over a larger range of values. This means that the price of the security can change dramatically over a short time period in either direction. A lower volatility means that a security's value does not fluctuate dramatically, but changes in value at a steady pace over a period of time.”

If you look at that closely, it starts to sound a little like one of the components of our mean reversion theory from my earlier post. If you remember, mean reversion happened when a security’s value was stretched beyond the statistical norm.  I’m doing my best not to get too complicated here… so stay with me. If mean reversion theory holds water, then more volatility (i.e. more statistical variance from the mean) should help us identify trades that meet our criteria.  Whew!  

Whether you got all that or not (and I really am trying to keep it simple), let’s just say we suspect that volatility is a good thing.  How do we find it? Volatility can be measured in a number of ways.  We can use Average True Range (ATR), Bolinger Bands, or just a simple measure of variance like standard deviation.  I created a measure using a pretty standard formula.  The code in AmiBroker looks like this:

HV10 = 100* StDev(log(C/Ref(C,-1)),10)*sqrt(242);

Now, I recognize that’s a mouthful, and probably looks very cryptic is your not an AmiBroker user, so to keep it simple just think HV10 is what we will call our “10-day Historical Volatility.  Again, there are different measures we could use, and some programs have indicators built-in for statistical volatility, or historical volatility.  For our example we’ll use HV10. 

That’s enough for now.  Next time we’ll look at the impact of this measure on results.

Good Trading…