Wednesday, July 12, 2017

Is "directional volatility" needed for trend followers?

What is needed is volatility coupled with price trends, which Ivarsson refers to as “directional volatility”. “What we at RPM look for is ‘directional volatility’, meaning volatility that drives markets in a certain direction”. - RPM’s executive Vice President Per Ivarsson

The concept of directional volatility is elusive. It combines two concepts, the path of prices with the price spread away from the average. The quote is focused on the critical need for a trend with volatility for trend-follower to profit. Volatility is necessary but not sufficient for strong trend-following profits. It is necessary to have prices move across a range in a discernible path, but a wide price range can still be without trends. Trends may occur if there is low volatility but the level of profits will be smaller and the trends will be harder to identify. 

The depiction of trend following as a look-back straddle is based on volatility and the ability of the trend follow to capture the range. The look-back option is the potential max that a trend follower may achieve for a single trade within a time span. Nevertheless, if we think of a stochastic process for a price series, we want a mean change plus wide dispersion. It is not enough to just have volatility, the journey expressed in the volatility is critical. 

We can graph the simplest case of a Monte Carlo simulation of a normal distribution with zero mean and a 10% annualized volatility to generate 10 paths for 252 days (one trading year) to show possible paths for prices. We have also included a set of paths with 10% volatility and a 5% annual mean. A given volatility does not ensure that that there will be a path that can reach extremes over simulated time period.  Though not surprising, a 10% volatility with zero mean will generate paths that look like there is no trend. However, there will also be some paths that do seem to generate trend behavior even though there is no mean. Similarly, the blue lines which simulate paths with a 5% annual mean show paths that do not seem to have any trends. Volatility will not guarantee you a path that will trend higher or lower. 

Directional volatility is good short-form phrase, but it is important to understand the parts that potentially can drive trends. Trend followers want spread in price but they need paths for profit.

No comments: