Beware of low volatility

July 26, 2016 01:00 PM

It is generally good to avoid stocks and futures markets that display low volatility. Whether you are a trend follower or countertrend trader, there are times that prices don’t move enough to produce a good return—in some cases, the price moves are less than the cost of trading.  There is also a tendency for prices to drift at these low-volatility times, rather than to trend. This drifting is not good for trend followers and small moves are not good for mean-reversion traders.

This condition also causes problems for portfolios. Most professional managers try to equally weight all the components in their portfolios. That is, they start every trade with equal risk and they may balance the market’s major sectors so that each one is contributing an equal amount of risk to the portfolio. This is probably the simplest way to create maximum diversification across a number of positions. But what happens in a portfolio of futures markets when the volatility of interest rates is very low? Nothing good, and it’s a condition that you need to be aware of regardless of your trading strategy or asset class.

Balancing futures

Let’s say we have a futures portfolio of two sectors—interest rates and equity stock indexes—and they are represented by Eurodollars and the E-mini S&P 500 contracts.

Next, we need a measure of volatility. We will do this by using the 20-day average true range, a technical measure that is similar to the high-low range of a price bar. To decide how many contracts we should trade on each signal, we divide an equal investment (say, $25,000) by the dollar value of the volatility. In “Volatility moves” (below), we see the back-adjusted futures prices for the S&P and the corresponding volatility of the market, which was at its highest in 2008. 

For Eurodollar futures, we see prices nearing 100 (the yield is 100 minus the price, so this represents today’s low interest rate environment). The market’s volatility is shown in the right chart. As you can see, it peaks in 2008 but then drops to very low dollar values by 2012.

Big problem

Whether you are trading stocks or futures, very low volatility means that you need to trade a much larger position to balance risk of the low-volatility markets against other markets that are not at low volatility.

“Balancing risk” (below) compares the number of futures contracts needed to trade the S&P 500 with the number of contracts needed to trade Eurodollars. If we were trading today, we need about 200 Eurodollar futures contracts for every 22 S&P 500 futures contracts to balance volatility risk across both markets. In 2014, we would have needed 1,200 Eurodollar contracts for about every 30 S&P 500 contracts.

While it’s typical that the general relationship persists between markets, with one typically more volatile than the other, the specific ratio changes significantly and frequently over time. Traders who aren’t aware of this and don’t respond accordingly can see some unexpected consequences from their trading strategies.

Event risk

Trading large orders presents difficulties in execution and liquidity. Volatility plays a role here, as well. You can’t expect to get a good price in a market with low volatility and generally low volume. We know that high volatility attracts the volume necessary for efficient trading and that low volatility does not.

Even more important is the hidden risk that is present when a trader holds a very large position. This can become a serious problem for large commodity trading advisors and professional futures funds managers, but it also can create issues for individual equity traders. Even a small point move when that move is larger than the average volatility applied to a large position, can be a very, very big profit or loss, but most often it is a loss because it was unexpected by the trader.

Risk worth return?

If there is big money to be made, even if it is from taking a large position, then the potential return on the trade needs to be worth the risk, but in some cases it’s not.

As an example, let’s look at a simple 80-day moving average system that is applied to Eurodollars. Here, we see a history of great returns, except for the past five years (“Average strategy returns,” below). While there may still be a small tendency toward profits (no commissions were included in these results, so that is suspect), the small gains from this strategy are offset by much larger risk that the trader is assuming with each position taken.

This is seen in the table below, which shows the results of trading Eurodollar futures from 1981 to 2010 and from 2010 to March 2016. As we can see in the ratio column the volatility of the market did not drop as much as the average rate of return.

                        AROR      Volatility     Ratio
From 2010
      0.097%    4.222%       0.023
Before 2010    4.678%    7.013%       0.667

Embrace volatility

Not all low-volatility periods are bad, but markets that have a concept of “high” and “low,” such as interest rates and commodities, can be very quiet when prices are extremely low.

The trigger for these low-volatility periods varies by market. Usually there are fundamental reasons for the low volatility. For grains, this means that once prices fall below the cost of production, we can expect price moves to shrink. For interest rates, the level that causes low volatility tends to be under 1% or 2% yields. For markets such as gold, you can get a good idea of what to expect from volatility by observing its history and preparing yourself accordingly.

For equity traders, low volatility may mean lack of interest in a stock. Along with that low interest goes lower volume and erratic price movement. 

Trading is difficult enough as it is. As an individual trader, you need to do all that you can to avoid low-volatility traps and remove unnecessary risk from the equation. This means recognizing a market that has low potential and high hidden risk in the form of low volatility.

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