Statistics  |  DEC 1998

The Volatility Edge by John Sweeney

Designing a profitable trading system is key, but the way that profits and losses vary can have an impact on your long-term success. In my previous article, I wrote that, other things being equal, a trading system with lower volatility would triumph over a system with higher volatility. To prove my point, I gave examples (and a small spreadsheet model) wherein a system with half the volatility of its competitor came out ahead 70-80% of the time when given the same sequence of trading results. Before we go any further, I should make a point of definition: Volatility is the variance of returns from the trades. The greater the dispersion of trading results, the greater the volatility. That said, the problem with a high-volatility system is that losses put a trader further in the hole, requiring greater percentage returns in order to recover. The classic example is starting with $100 and trying to get to $120, a 20% return. If, instead, you first lose 20%, you must have a 50% return on $80 to reach your initial goal of $120 on the next trade.

by John Sweeney