‘Equalising volatility’ was one of those concepts that experienced traders always knew about. But, it was only after fast computers became available that volatility could be quantified in real-time.
Most long-term investors understand the value of keeping equal holdings (as far as possible) in different stocks. An investor has little idea which stocks will see big positive movements and which ones will see big negative moves. By keeping equal weights in each stock, he can ensure that the impact of an extraordinary move will not be disastrous.
A trader has a trickier task since he’s usually employing leveraged instruments and if possible, he would like to maximise the impact of winners while he minimises the impact of losers. It’s common for a trader to have several margined positions open at the same time and his strategy could involve pyramiding.
The ability to take positions of equal size is constrained by designated market lots. In theory, lots are supposed to roughly equal. But in practice, as prices change, wide variations develop in lot size.
Different instruments also have different volatility and therefore, two leveraged positions of roughly equal sizes could have very different volatility patterns.
A trader needs to know this and to cater for it since it directly affects the risk of loss. Let’s say for example, a trader holds two different stocks with roughly equal lots. A stock futures position has about 7:1 leverage (the total margin is about 15 per cent of position size). One stock has a habit of swinging five per cent a day whereas the other tends to move about two per cent.
The two similar-looking exposures actually carry very different levels of risks. The more volatile stock swings more than twice as much as the less volatile one. The trader could lose one-third of his margin on a normal day if a position in that stock went against him. If the trader wants exposures with equal levels of risk in both stocks, he would have to hold five lots of the less volatile stock for every two lots of the more volatile stock.
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Most traders in the pre-computer era did back-of-the-envelope calculations to estimate volatility with the small data samples that human brains and desk calculators can handle. Smart traders started seeking more rigorous ways of calculating volatility differences in the PC-era.
There are many different ways of calculating volatility and the trader can choose the one he likes. But, he should definitely use at least one of them and preferably a couple. Otherwise, he’s guaranteed to run into unpleasant surprises.