Lesson 20 of 25 · 6 min

Why volatility targeting mechanically forces selling

A rule that holds risk constant must change position size, and the direction is decided before anyone looks at a price.

Some pools of capital are run to a volatility target rather than to a view about value. The rule is arithmetic, it is published in advance, and its consequences follow without anybody forming an opinion.

exposure = target volatility ÷ realised volatility

exposure: The fraction of capital held in the risky holding. Above one means borrowing; below one means holding cash.
target volatility: The annualised volatility the pool is managed to deliver. A fixed policy number.
realised volatility: The recently measured volatility of the holding, computed over whatever window the rule specifies.

Take an illustrative target of 10 percent. When realised volatility is 12.4 percent the rule holds 10 ÷ 12.4 = 80.65 percent of capital in the holding. When realised volatility prints 27.1 percent the rule holds 10 ÷ 27.1 = 36.90 percent. Moving from the first state to the second sells (80.65 − 36.90) ÷ 80.65 = 54.24 percent of the position.

In currency, on $4,600,000 of capital, exposure falls from $3,709,677.42 to $1,697,416.97 — $2,012,260.45 of selling produced by a division. No view was formed about whether the holding was cheap. The formula consumed a published statistic and returned a number of shares.

Two properties make this matter beyond the pool itself. The selling is not discretionary, so it does not stop because prices look attractive; and the input rose because prices fell, so the largest sales follow the largest declines. Lesson 5's clustering compounds it further: the rule keeps selling for as long as magnitudes stay elevated, which is precisely as long as the cluster lasts.

The landing for a pledged portfolio is one of timing rather than of participation. A borrower need own none of this. The supply arrives in the same sessions in which a lender's model, reading approximately the same volatility statistic, widens the haircut on the borrower's collateral. Two unrelated mechanisms read one input and both push the same way, which is the subject of lesson 24.

Key terms

Volatility target: A policy that fixes the volatility a pool of capital delivers rather than the amount it holds. Position size becomes the adjusting variable.
Exposure ratio: Target volatility divided by realised volatility. It falls as volatility rises, which converts a measurement into an instruction to reduce.
Mechanical flow: Buying or selling produced by a formula rather than a judgement. It is insensitive to price, which is why it does not stop when prices fall.

Worked example

One rule, two volatility prints, $2 million of selling

An illustrative pool with $4,600,000 of capital and a 10 percent volatility target. Only realised volatility changes.

Realised volatility 12.4%: Exposure 80.65%
Holding at that exposure: $3,709,677.42
Realised volatility 27.1%: Exposure 36.90%
Holding at that exposure: $1,697,416.97
Amount sold: $2,012,260.45
Share of the position sold: 54.24%

More than half the position was sold by a division. The only judgement in the chain was the decision to adopt the target, and that was made years earlier.

Check yourself

A pool targets 10 percent volatility. Realised volatility goes from 12.4 percent to 27.1 percent. What share of the position does the rule sell?

Saved in this browser only. No account, nothing sent anywhere.

Educational only. Nothing in this lesson is investment, legal or tax advice, or a recommendation to enter into any transaction. Figures are illustrative and computed from the inputs stated in the lesson.