Good Volatility Vs Bad Volatility

Good Volatility Vs Bad Volatility
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Is volatility the same as risk? Algorithmic trading pros separate volatility into different measures of risk.  So why didn’t Nobel Prize winner Harry Markowitz do the same?

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View volatility risk from a different perspective

Scot Billington from Covenant Capital Management, a momentum fund with a 15 year track record with $500 million in management, thinks risk can be viewed from a different angle.

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Markowitz and Sharpe did not distinguish between upside and downside volatility

Markowitz and his Nobel Prize winning colleague William Sharp both believe the higher the volatility the riskier the investment.  In other words, the more an investment moves up and down in price the riskier that investment.  At issue, however, is the treatment to upside vs downside volatility. Sharpe and Markowitz says positive volatility, when an investment is making money, has the same risk weighting as negative volatility, when an investment is falling. The popular thesis in the managed futures industry is that upside volatility has a lower degree of risk than negative downside volatility.  This concept was discussed in 2010 in the book High Performance Managed Futures.  The reason it is significant is that a momentum strategy, such as that utilized by Covenant or Cliff Asness at AQR is that sophisticated trend followers are known to have different risk management regimes for upside vs downside volatility. While the final trading formulas of most algorithms are closely guarded secrets, all algorithms can be categorized based on core market environment forces.  Price persistence – or the price of an asset continuing to move in the same direction – is the market environment known to favor trend following.

Challenging a gang of Nobel Prize winners: Upside deviation carries less risk

This is the thinking challenging Nobel Prize winners Sharpe and Markowitz that Billington now brings to a head. In the Futures Magazine article, “This leads us to a different way to view risk. Risk is the difference between the anticipated worst loss and the realized worst loss,” Billington wrote.  “When viewed through this lens, lower volatility equals higher risk.” Billington then considered various portfolios based on worst drawdown and volatility.  The result of this exercise, well known in the managed futures industry, is that adding the proper dose of volatility to a program can actually reduce the overall portfolio volatility.  It’s like eyeing your cake and eating it too. At the end of the day Markowitz and Sharpe received Nobel prizes for what is considered a faulty risk modeling algorithm. “Can Nobel prizes be taken back,” joked Lincoln Ellis from Green Square the $2 billion family office.  Ellis utilizes volatility pairing to build portfolios designed to operate in both positive and negative stock market environments and considers upside volatility less risky than the downside variety.

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Mark Melin is an alternative investment practitioner whose specialty is recognizing a trading program’s strategy and mapping it to a market environment and performance driver. He provides analysis of managed futures investment performance and commentary regarding related managed futures market environment. A portfolio and industry consultant, he was an adjunct instructor in managed futures at Northwestern University / Chicago and has written or edited three books, including High Performance Managed Futures (Wiley 2010) and The Chicago Board of Trade’s Handbook of Futures and Options (McGraw-Hill 2008). Mark was director of the managed futures division at Alaron Trading until they were acquired by Peregrine Financial Group in 2009, where he was a registered associated person (National Futures Association NFA ID#: 0348336). Mark has also worked as a Commodity Trading Advisor himself, trading a short volatility options portfolio across the yield curve, and was an independent consultant to various broker dealers and futures exchanges, including OneChicago, the single stock futures exchange, and the Chicago Board of Trade. He is also Editor, Opalesque Futures Intelligence and Editor, Opalesque Futures Strategies. - Contact: Mmelin(at)
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  1. ??? Markowitz devotes an entire chapter (IX) to semivariance in his seminal 1959 book. He argues
    that “analyses based on S [semivariance] tend to produce better portfolios than those based on V [variance]”, and “semivariance is the more plausible measure of risk.”

    Markowitz suggests variance has an edge over semivariance “with respect to cost, convenience, and familiarity”. The cost & convenience difference of comupting these measures has since been eliminated…

    CVaR, VaR, MVaR, Omega, Max DD (Draw Down) were all rejected by Markowitz as valid risk measures because the do not have any utility theory support.

    There is nothing different about this “angle” with extensive downside risk literature dating back to the 1970s. That’s great to challenge / criticize, however, it should be accompanied by a thorough understanding of the material.

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