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Random Regime Musings

August 4, 2010 david varadi Leave a comment Go to comments

It is now well-known that historical volatility is a significant moderator of mean-reversion

performance. This is just common sense, and is strongly supported by the research. Another good
recap (and great visual) was done by Jeff Pietsch of the cool new site ETF Prophet
http://etfprophet.com/relative-volatility-comparative-mean-reversion-strategy-performance/and
formerly of Market Rewind fame. In this post Jeff shows how a 3-year relative ranking of 100-day
historical volatility had a substantial impact on a basic RSI2 strategy. Another series of posts that
break things down in a more detailed and simple manner that is easy to follow was done by
Woodshedder http://ibankcoin.com/woodshedderblog/2010/07/19/part-4-the-secret-ingredient/. The
use of shorter or more complex transforms/measurements of volatility can boost separation in mean-
reversion returns even more. But that is not the point—in fact, the point is that we are using
historical volatility in some way or another to determine what to do right now with our trading.

Now here I am going to connect some dots:

Fact 1: We can measure how 30-day volatility has historically affected a simple mean-reversion
strategy by separating the readings into different quartiles or quintiles. These can represent different
volatility regimes.

Fact 2: Using this regime information we can actually improve strategy performance out of sample
by moderating bet size or exposure. However, there is inherent lag in responding to indicators that
measure current historical volatility.

Fact 3: Volatility–lets say 30-day volatility– can be predicted far more reliably than market prices
using even simple projection models. The use of volatility projection models (EGARCH etc) is well
established in academia and considered to be fairly robust.

Conclusion: Using predicted or projected volatility will substantially aid in regime-based strategy
exposure models. In English, by using forward estimates we can respond more quickly to changes
in volatility and how they will impact our mean-reversion strategies.
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Comments (4) Trackbacks (1) Leave a comment Trackback

1.
The Quanting Dutchman
August 4, 2010 at 12:27 pm | #1
Reply | Quote

Hi David,
I like this good summary of volatility impclications and the convincing conclusions. The other
day I was skimming through Tony Cooper’s winning paper of the 2010 NAAIM conference
(http://www.naaim.org/default.aspx) I remember that the subject was on volatility of volatility
and how predictable it is. I think it may be interesting to bring this in. Will look into this as
well.
Regards, Michel


david varadi
August 5, 2010 at 2:02 am | #2
Reply | Quote

Hi Michel, thanks very much and welcome to the blogosphere! some good work so far.
best
david

2.
Jez Liberty
August 5, 2010 at 8:47 am | #3
Reply | Quote

true that volatility is interesting because of its higher predictability, which I guess makes for a
nice(r) piece of data for regime switching..
Thanks for the post, that’s given me some motivation to do some analysis on impact of
volatility on Trend Following returns.

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Random Regime Musings « CSS Analytics Page 3 of 5

@Quanting Dutchman: cool new blog indeed! Just added you to my blogroll – hope that
helps…

3.
Mrkt_Rwnd
August 5, 2010 at 8:19 pm | #4
Reply | Quote

Hi, I don’t think I wrote that those were the HV parameters. In fact, I didnt’ mention it at all!

Rechecking my code, it was in fact an HV of 100 normalized using a 252-period percent rank.

Cheers, J ~~

1. August 11, 2010 at 6:53 pm | #1

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