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Risk v. Volatility: Trend Followers Know the Difference

Volatility and risk are not the same thing.

Volatility is the up and down nature of markets. If your trading strategy expects the markets to move up and down, as markets often do, then you must be ready to deal with volatility specifically each and every day.

If you risk 2% of your original capital on a particular trade, that is a real risk of capital. Controlling risk is an absolute foundation of money management.

Nicole Meaden of TASS compared monthly standard deviations (volatility as measured from the mean) and semi-standard deviations (volatility measured on the downside only) and found that while trend followers experience a lot of volatility, it is concentrated on the upside, not the downside.

Meaden stated: “Trend followers cut their losses and let their profits run. I think the turtles are a classic case of a group of managers whose overall performance is unduly penalized by people looking too closely at the Sharpe Ratio”. The Sharpe ratio does not reveal whether volatility is on the plus or the minus side. Most turtles’ volatility is on the plus side or they would not be in business. The difference between the standard deviation and the semi-standard deviation is what counts. The actual formula for calculating them is identical, with one exception: the semi-standard deviation looks only at observations below the mean.

Meaden argues that if the semi-standard deviation is lower than the standard deviation, the historical pull away from the mean has to be on the plus side. If it is higher, it means the pull away from the mean is on the minus side. Comparing monthly standard and semi-standard deviation for trend followers we find the comparison showing 12.51 for the former, and 5.79 for the latter. Meaden believes this is a huge difference that puts most of trend following volatility on the upside.

Sources: Managed Derivatives Magazine

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