How to use volatility to configure the CTA strategy from Market Timing?

Introduction of Volatility

Types of volatility:

There are two types of market volatility:
Historical volatility, which makes observations by looking back；
Implied volatility, which makes predictions by looking forward

Historical volatility (HV), as the name implies, deals with the past. It’s found by observing a security’s performance over a previous, set interval, and noting how much its price has deviated from its own average.

If historical volatility is going up, it’s a cause for caution, as that can indicate something happening or about to happen with the underlying security. If it’s going down, it means things are returning to normal and stabilizing.

Implied volatility (IV), aka future volatility, is more complicated. It’s a forecast of an asset’s future activity based on its option prices. (Quick refresher: an option is a contract giving the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price on or before a certain date.)

Reference: what-is-volatility

Formula of volatility

Historical Volatility:
Step1_Calculate Hourly Returns
Return = (Ending Price / Beginning Price) – 1
However for all practical purposes and ease of calculation, this equation can be approximated to:
Return = LN (Ending Price / Beginning Price)
Step2_Use the STDDEV Function
Daily Volatility = STDDEV(Return) SQRT(24)
Weekly Volatility = STDDEV(Return) SQRT(7*24)

Implied volatility:
The IV equation described above is known as the Black-Sholes formula, a mathematical model designed to price options on the stock market. It looks like this:

It isn’t necessary that you understand every aspect of the formula to be able to grasp the concept of implied volatility, but noting the position of the six crucial elements can be helpful. On the far left, C stands for the call option price, with the normal distribution (N), spot price (St), strike price (K), risk-free interest rate (r), and time to maturity (t) on the right side of the equals sign, and implied volatility (σ or sigma) buried within the formulas for d1 and d2. (This is why you need to back-solve to find it, as the above equation solves for C.)

Reference: volatility-calculation-historical

Interpretation of volatility

High volatility is clearly related to greater risk, but low volatility may also mean that there is a smaller chance for profits. The following are reasonable expectations for selecting trades based on volatility: • Entering on very high volatility is exposure to very high risk. Returns from high volatility trades may range from large profits to large losses. The net results may be a profit, but the return-to-risk ratio is likely to decline. Long-term performance may be best if these trades are avoided. Entering on extreme low volatility seems safe, but prices often have no direction and produce small, frequent losses. Waiting for an increase in activity before entering might improve returns. Contrary to this, some traders advocate entries when prices have had a short-term drop in volatility. • Exiting a position when prices become very volatile should reduce both profits and risk, but may come too late. This is an issue best resolved by uating the specific .

Eliminate or Delay? Whenever a high or low volatility situation occurs at the time of an entry signal, there are two choices. The trade can be completely eliminated by filtering, or it can be delayed until the high volatility drops or the low volatility increases to an acceptable level. When a trade is filtered, it is necessary to track the trade that was not entered, to know when it was completed. Each new trade is subject to the volatility threshold at the time of its entry. A trade that is delayed pending a change in volatility can be entered any time volatility moves back into the acceptable range. The following sections will discuss CTA timing strategies in more detail. Before we begin, it can be theorized that short-term CTA strategies are likely to need to eliminate (rather than delay) timing opportunities that are outside an acceptable range of volatility, as CTA strategies are often ineffective for extended periods of time, with net asset values deteriorating within a certain range and experiencing long periods of drawdowns. For clients looking to invest in CTA strategies for the long term, the best approach is to delay entry and wait for the volatility to reach an appropriate level before timing the entry, such as entering during low volatility after it has reached an acceptable level. This can effectively avoid the net asset value being in a negative state for an extended period of time.

Application of Volatility:

Weekly market environment analysis can assist in timing the allocation of CTA strategy portfolios. The timing of entry into an investment in a CTA strategy portfolio can be filtered or delayed. When the market volatility reaches extremely high or low levels, and the ratio of returns to risks is poor, the weight of CTA strategies can be reduced or the configuration of CTA strategies can be terminated. The best entry timing is to wait for high volatility to decline or low volatility to rise to an acceptable level before entering at an appropriate time. However, we need to use statistical analysis of historical data to describe whether the current volatility level is high or low, and what level of volatility is acceptable, so as to filter or delay entry. DC_Bot keeps pace with market environment changes and regularly writes reports to assist clients in analyzing the current market volatility environment, providing advice on the best timing points for configuration.

1.Historical volatility statistics for 2022

Yellow Line is Bitcoin, blue line is Ethereum, the left side is the historical volatility level of BTC and ETH at each time point, the right side is the distribution map of historical volatility, and the green and red dotted lines represent the historical volatility in 2022, respectively Rates in the 20% and 80% quantile values, this graph allows us to clearly understand what range the historical volatility of Bitcoin and Ethereum is too high or too low in 2022, so as to predict on the historical volatility in 2023 high and low.

2.2022 implied volatility statistics

Yellow Line is Bitcoin, blue line is Ethereum, the left side is the implied volatility level of BTC and ETH at each time point, the right side is the distribution map of implied volatility, and the green and red dotted lines represent the year 2022 respectively The value of the implied volatility in the 20% and 80% quantiles, this graph can let us clearly understand the range of the implied volatility of Bitcoin and Ethereum in 2022 is too high or too low, so as to speculate that in 2023 High and low annual implied volatility values.

3.Example Volatility Report for January 2023

The figure above shows this month’s volatility report. The first part will explain the volatility status, the second part will have a chart showing the volatility changes this month, and the third part will be a table describing the specific changes and the current volatility. It is in the quantile position relative to 2022, representing the current level of volatility. DCBot hopes to help you and me better choose the timing of investment through regular volatility data analysis.

Disclosure: This article is from DCBot, Crypto Hedge Fund who provide CTA, statistical arbitrage, algorithmic trading, and high-frequency trading. For more information on DCBot, please visit https://dcbot.ai/