Volatility got you in a spin?
One of the things I love about research is the “ah-ha” moment when I see something that has not been so obvious before. It’s like the veil has been lifted and suddenly I see that condition everywhere.
Just this last week, Julius de Kempenaer and I were working on a couple of things with the Relative Rotation Graphs® (RRGs). While I was writing a section on the distance of securities from the centre of an RRG, I had one of those “ah-ha” moments.
Let me connect the dots for you… (yes, that is a bad RRG related pun). We know from experience/observation that returns are higher from the securities that are further away from the centre of the RRG chart. This means that the securities must be outperforming the benchmark and achieving Alpha (excess returns). We also know that Alpha comes from the more volatile stocks. Knowing this, would it be accurate to assume that the stocks on the outside of the RRG are in fact those with higher volatility?
First, let’s deal with “Volatility”—that poor term has been ridiculed, mocked, and used as the whipping post of every failed trade. “I would have made money, but the market was too volatile”. The truth is that without volatile stocks we would never have the opportunity to outperform the market. It would be the nirvana of the proponents of Efficient Markets where everyone is “rational” and no one would ever overreact to an event like…say…the election of a President?
Volatility is often portrayed in the negative sense, but there are definitely two sides to this coin. The volatile reaction is most likely followed by a volatile counter-reaction. The ideal is if we can find securities that are volatile and have already been beaten down. Ie mean reversion. This would give us the opportunity to make some quick early gains. Even as a long-term position trader early gains are a good thing. The stop can be moved, so the trade becomes risk free, and the trade is left to run.
That’s the idea of the distance on the RRG chart. We’ve talked about distance before, but we have never thought about it in terms of Volatility. Yet again this simple financial visualisation is giving us insights into market structure. The theory is that there is a correlation between distance from the centre of the chart and security’s volatility. We’ll need to do some quick testing.
In this WatchList I have the whole S&P 500 and in the first column I have listed the 14-period ATR as a percentage of the close price. Since the ATR value is different for each security, we need to normalise the value so we can compare them. Dividing them by the security’s close price is a good way to do that. I also sorted the WatchList by this column with the most volatile stocks at the top of the list. In the next column I have the security’s distance from the centre of the Weekly RRG chart. So you can see it visually, I also have all of the S&P 500 on the RRG chart. In this case I set the tails to two periods to reduce the tail spaghetti on the chart.
The hypothesis that we are forming, based on the observations, is that there is a correlation between the ATR value and the RRG Distance. By adjusting the sorting of the columns we can observe that there is indeed a correlation—but how strong is it?
We can use the “Send To” feature and send the WatchList values to Excel and then complete a correlation on the two columns.
What it’s telling us is that there is moderate-to-strong positive correlation between the two columns. Essentially this is telling us that there certainly is a significant relationship between the distance on a RRG and the volatility of that security.
Why is this important? We’ve already talked about how RRGs can be used to identify the early Relative Strength and how that can lead to Absolute Returns. Now we can add the extra dimension of Volatility by looking at the distance of the chart. When we are presented with multiple opportunities, we can factor in volatility to our decision process.
In this case, If I wanted a more volatile security, I might consider FootLocker (Red Arrow), but if I wanted a safer security, I would look at Tractor Supply Co (Green Arrow). Granted it’s not near the centre of the chart, so there will still be some volatility, but just not as much as FL. They are both valued around $55 and both starting to point in the right direction (North East), but the RRG is telling me that FL is more volatile. Of course I always want to check. Here they are charted, you can see that FL is indeed more volatile at just under 1% more volatility.
This is a quick look at another relationship that is easily seen with RRGs. There are so many ways that unrestricted RRGs can be used to help in both security selection and portfolio management. Of course there are more issues that need to be considered, but if you are looking for an easy way to visually identify the more volatile securities, then this may help. If you would like to know more, let us know.
Mathew Verdouw, CMT, CFTe
CEO / Founder Optuma
As a Computer Systems Engineer, Mathew started Market Analyst (now Optuma) within 18 months of completing his degree. From that point on, Mathew has made it his mission to build the very best software tools available.
Since 1996 Mathew has been learning about all aspects of financial analysis, and in 2014 earned the CMT designation (Chartered Market Technician). In 2015, he was also awarded the CFTe designation. As someone who has dedicated his life to find better ways to analyse financial markets, Mathew is set to drive innovation in this sector for many years to come.