It is very difficult to separate the concepts of volatility and risk, the two are intimately intertwined. Look no further than the pending Federal Reserve rate decision at time of this writing. Most traders have taken to the sidelines to wait for the decision from the Federal Reserve. Will they raise rates? Will they keep rates the same? Will they not? This is been the permeating question during this last quarter. It is also a question of value. How much does the answer impact in the markets. As a result, strategies are formed, and bets are placed, and risk is managed accordingly. The concept is quite simple but is sometimes difficult in practice. Commonly referred to as the three C's; First there needs to be a concept of what's going on, second one must have conviction to initiate positions, third (and possibly most importantly) there better be a contingency plan in case it goes wrong. All traders know this, and understand this, and it becomes the mechanics for managing risk in a volatile environment.
Different risk events (meaning news events) present different levels of “potential volatility”, and the expectation regarding each will affect the level of “reactionary volatility”. Where this becomes important is recognizing each, assigning a value, and positioning based upon what the net might be. Looking back to the Federal Reserve announcement example, it is presumed there are three main possible outcomes: rate increase, verbiage change, or no change. During the week prior to the rate announcement, there was preliminary volatility as participants adjusted their holdings in anticipation of FOMC. Then, just prior to the announcement, there was market asystole, or complete lack of volatility. Positioning had been completed, and then everyone waited for guidance from the Federal Reserve. What we received was guidance for a holding pattern, possibly into 2016. With this news, the volatility was somewhat muted, with what now appears to be a re-pricing of the potential rate decisions, and their potential time horizons.
There is a value associated with scheduled and unscheduled events. The ever-pending Fed announcement is by far one of the biggest events currently on the schedule, and it is a "scheduled" event. Vastly different would be the unexpected (and unscheduled) Swiss National Bank announcement of unpegging their currency (early 2015), or the turmoil surrounding China during Q3 of 2015. More on point though, the unknown/unscheduled events moved markets swiftly and aggressively, because there was not an expectation priced into the market for these. Both were truly “black swan” or outlier events. Normal day-to-day volatility does ebb and flow based upon a number of different market variables. For most managers and traders, it is exactly these variables that allow us to evaluate risk and volatility parameters in the market, and make informed trade decisions. It is the unknown, and unscheduled, that managers must attempt to take into account, and attempt to account for. With irony, and adding complexity to the equation, it seems there has been a influx of what was once considered “black swan” events - unpredictable outlier events, which by there unknown nature cause sizeable market reactions. The result has been an evolution to what can be described as “50 shades of grey swan” event.
Knowing thyself, and knowing thy tolerance for risk, is very important in helping to form a trade strategy. It is also of importance to have an understanding of how to calculate risk. It is darn near impossible to fully calculate all possible outcomes, and derive a “complete” risk profile for a given market. Complicating this is the fact that markets are dynamic, and are comprised of the sum of all information presently available to it. Risk and volatility ebb and flow on a second-by-second basis. Entire trading programs are coded to measure actual versus expectation, and make trade “decisions” accordingly on a scale of nanoseconds. Volatility, and one’s perception of volatility, is somewhat of a relative term to the manager, and/or the investment vehicle. It can have many different causes, measures, and its effect can be observed in many different fractals. For example, what might be volatile to one person might be nothing more than background noise to another trader. What might be considered a “highly volatile” investment, might be appropriate for another. As an investor it is highly important to choose a money manager whose risk parameters and trading methodology aligns with their own risk tolerances. Managed Futures can be a fantastic vehicle for an investor to round out their portfolios, but it is advisable to have a good understanding of the methodology of the manager before investing.
So the question is, “how has volatility benefitted or hurt the markets over the past quarter?”. It must first be stated that the volatility seen has been absolutely astounding. Large and aggressive moves, initiated by news driven events, some of which were not able to be predicted, have become more standard. Attempting to either ride out large moves, or nimbly pecking into and out of the markets as a means to minimize risk have become two courses of action for most managers. If you have a trading background, then this is one of those once-in-a-lifetime events where you are right in your sweet spot. For the longer-term buy-and-hold populations, it can be gut wrenching, but like most times of market volatility, this past year will eventually be viewed as an anomaly. It must be noted though, that some of the volatility seen during this past quarter has raised concern.
It is believed it is wrong to place blame for such volatility at the feet of the HFT alter. These firms, and their methodology, are no more to blame than those who are discretionary traders. Both populations are part of the aggregated information in the marketplace, and have a certain predictably of influence. The forever pending FOMC decision to raise rates will have a volatile effect upon the markets, but Mrs. Yellen, and her peers, have done a good job of articulating intentions. As such, market reactions should be sizeable but not catastrophic. Where the greatest risk lies is with the 5 standard deviation, bonafide outlier, the account killer. These events, by their unpredictable nature, are the greatest concern, but are the most infrequent.
Adrian V. Fleisher is Principal of Ten Yard Capital, a Commodity Trading Adviser specializing in the spot currency marketplace. www.tenyadcapital.com
This article is by no means a recommendation for trading activity. Investing in commodities carries with it a certain degree of risk, and as such, potential investors should evaluate if an investment with a CTA, or if managed futures is appropriate for them. Please research before you invest!
Adrian V. Fleisher M.S., M.B.A.
Principal
Ten Yard Capital, LLC
