Volatility timing is an investment approach in which the manager adjusts the amount of exposure of the portfolio based on the volatility of the market. In other words, volatility timing is a type of volatility position sizing or volatility targeting. On this page, we explain how volatility timing works and why the approach tends to improve risk-adjusted performance. Volatility timing can easily be implemented using spreadsheet software.
Volatility timing definition
Volatility timing is a trading approach whereby the manager adjusts the portfolio’s exposure to the stock market based on his or her forecast of what volatility will be in the future. By timing volatility, the investor can improve his or her risk-adjusted performance. To illustrate why this works, consider the Sharpe ratio:
By timing market volatility, we can lower the denominator in the Sharpe ratio. A lower denominator will increase the Sharpe ratio of the portfolio. This is a kind of a market timing strategy.
How to do volatility timing?
There are different ways to perform volatility timing. One the one hand, the investor can try to forecast volatility in the next month. This can be done by forecasting volatility using and EWMA or a GARCH model. If he expects a lot of volatility, he can decide to lower his or her positions. If, however, the investor thinks the level of volatility will decrease, he may add to his existing positions or take more leverage.
On the other hand, the manager can also decide not to forecast, but rather to just adjust the portfolio based on past volatility. There is some recent evidence that this too, may improve the performance of the portfolio. Hence, volatility forecasting is not necessary to perform volatility timing. In particular, risk-adjusted performance improves. To see why this may be the case, let’s go back to the Sharpe ratio.
When volatility goes up, it tends to stay elevated for quite some time. Hence, when volatility is high today, it will probably be pretty high tomorrow as well. The numerator of the Sharpe ratio (the expected return) however, tends to change more gradually. This means that, when volatility goes up, the risk-return trade-off worsens. That’s because, while the denominator increases, the numerator stays the same. Since that will be the case for quite some time, it’s better for the manager to lower his exposure.
Interestingly, the opposite is also true. When the volatility is quite low, the risk-return trade-off is favorable. In that the case, the Sharpe ratio is quite high, and will probably remain high in the near future. In that case, it’s better to increase the exposure to the market further.
The portfolio that results from such an approach is called a volatility managed portfolio.
Volatility timing position sizing
To perform volatitlity timing, the first thing that we should do is a volatility calculation. In particular, what we will do is calculate the realized volatility over the previous month. Using that information, we can then determine our position size. In particular, let’s assume we target 20% volatility. If volatility was higher the previous month, we scale back the position. If volatility is lower than 20%, we use leverage to increase the volatility of the portfolio back to 20%.
On this page, we discussed timing using volatility, which is basically a kind of volatility targeting. The approach is said to improve risk-adjusted returns by lowering the volatility of the portfolio.