Examining The Important Link Between Volatility and Drawdown

Jun 01, 2010 in Drawdown | Volatility

You hear the term ‘volatility’ thrown around a lot but it is really not well understood outside of the options market community.  Ask people outside the options community how to calculate volatility and they will likely stutter (including professional advisors).  

Using a chart in combination with volatility can visually show the important link between volatility and ‘drawdown.’  This chart looks at a simple comparison between the Barclays Aggregate Bond Index, the S&P 500 and the ProShares 2x Leveraged Long S&P 500 ETF.

ETF Charts

In this case, we know that the ProShares fund has exactly 2x the daily volatility of the S&P by design and so we expect it to have 2x the daily volatility, by definition (excluding tracking error and any expense ratio differences – which are usually trivial).    

But we would like to take this one step further -- as you observe various indexes, you can and should use the relative volatility of any ETF as a general guide to how much it may lose relative to the market in a correction.  It’s not that the precise historical volatility figure will predict the future volatility, it won’t.   But the historical volatility will offer a very good estimate of the RELATIVE size of a correction vs something like the S&P 500.

It’s a good rule to remember: the higher the volatility, the higher the drawdown.   If you buy and hold the most volatile ETFs, it’s just a matter of time before you will face a significant drawdown.   

Below is a chart that replaces the ProShares 2x ETF with an unlevered fund:  the very popular Brazil fund (EWZ).   

ETF Charts

Note the extremely high relative volatility --- and the larger drawdown.  If I graph volatility historically, you will see that in every observed instance, EWZ is materially more volatile than the S&P 500.   This does not by itself make EWZ unattractive – it depends on your return forecast for EWZ.   Should your return forecast for EWZ justify the increased volatility, then this is good news -- you would own it.

Summary:  the securities with the highest marginal contribution to portfolio risk should provide the highest expected returns.  This entirely logical concept tells the portfolio manager if their portfolio positioning is consistent with their own beliefs.



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Comments (4) -

Jun 01, 2010 15:49 #

Thanks for your blog entries. As a new investor I am looking for simple, clear and rational explanations about how to interpret basic trading terms like volatility. I have only found your site over the past few days. It has already become one of my favorites. Cheers!

Albertaguy Canada

Jun 22, 2010 18:29 #

Excellent website and great commentary.  I've grown to despise volatility, so your website has become one of my favorites, as it goes a long way towards reducing the  volatility in my etf plays.

clacy United States

Aug 28, 2010 10:03 #

Your site is terrific and has quickly become one of my favorites.

Can you explain in more detail exactly how you calculate volatility?  It seems like there are lots of ways the term is used but I am unclear how you derive your numbers.



Steve United States

Nov 03, 2010 19:40 #

Great post.

Richard United States

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