When ranking a market analysts usually pick the percent performance since a given date as their key figure. If a stock has been at 100 last year and trades at 150 today, percent performance would show you a 50% gain (A). If another stock would only give a 30% gain (B), most people now would draw the conclusion that stock A would have been the better investment. But does this reflect reality?
Percent Performance and Volatility
In reality and as a trader I would never just buy and hold my position, I would always adjust my position size somehow related to the risk in it. I like instruments that rise smoothly, not the roller coaster ones which will only ruin my nerves. So ranking a market solely by percent performance is an useless statistic for me.
Lets continue with our example from above: if stock A, the one who made 50% has had a 10% volatility, and stock B, the 30% gainer, only had a 5% volatility, I surely would like to see stock B on top of my ranking list, and not the high vola but also high gain stock A.
Risking the same amount of money would have given me a bigger win with stock B.
Combining Performance and Volatility
To get stock B up in my ranking list I will have to combine the absolute gain with the market volatility in between. This can be done quite simple. Just add up the daily changes of the stock, normalized by market volatility.Have a look at the formula of this new indicator:
index(today)=index(yesterday)+(price(today)-price(yesterday))/(1.95*stdev(price(yesterday)-price(2 days ago),21))
In plain English: Today’s Vola Return Index equals yesterdays Vola Return Index plus the daily gain normalized by volatility
So if the index has been at 100, the volatility (as a 95% confidence interval over 21 days) is 1 and the stock made 2 points since yesterday, then today’s index would be 100 + 2/1 = 3
Vola Return Index vs. Percent Return Index
Lets have a look at a sample chart to compare the 2 ranking methods. I therefore picked the J.P.Morgan stock.
The upper indicator shows you a percent gain index. It sums up the daily percent gains of the stock movement, basically giving you an impression what you would have won when you would have kept your invested money constant.
The indicator on the bottom is the Vola Return Index. It represents your wins if you would have kept the risk invested into the stock constant. (=e.g. always invest 100$ on the 21 day 95%confidence interval of the daily returns)
Have a closer look at the differences of these two indicators up to October 2016. JPM is slightly up, and that`s why the percent change index is also in the positive area. During the same time the Vola Return Index just fluctuates around the zero line, as the volatility of JPM picked up during this period of time. To keep your risk invested constant over this period of time you would have downsized your position when JPMs volatility picked up, usually during a draw down. No good.
The same can be observed on the upper chart, showing the last months movements of the index. Right now, after the recent correction the percent change index is, like the JPM stock, up again. On the other side the Vola Return Index is still down, due to the rising volatility in JPM.
Vola Return Index – Ranking
Lets put this to a test and rank the 30 Dow Jones industrial stocks according to the percent return index and using my Vola Return Index as a comparison, calculated since 01/01/2015.
The first three stocks are the same, they got the highest vola and highest percent return. But JPM and Visa would get a different sorting. Just see how low the JPM Vola Index is, it would not be the 4th best stock.
Percent returns says JPM and Visa are abou the same, only the Vola Return Index shows that VISA would have been the better investment vehicle compared to JPM. But see for yourself on the chart…
Make sure your indicators show what you actually can do on the market. There is no use in just showing the percent gains of a stock if you trade some kind of VAR adjusted trading style.
Keeping you risk under control is one of the most important things in trading, and using the Vola Return Index instead of just plotting the percent performance can give you some key insights and keep you away from bad investment vehicles. Also have a look at this stock picking portfolio based on similar ideas.
Tradesignal Equilla Code for Vola Return Index: