Lesson 21 of 25 · 7 min

Volatility as a trigger inside other people's rules

Your headroom depends on rules you are not party to, and nearly all of them read the same input your lender does.

A volatility figure does not enter one model. It enters many, maintained by parties with no knowledge of each other, and the fact that they share an input is what makes their responses arrive together.

Rules that take a volatility figure as an input:

A lender's advance-rate model, as lesson 16 worked through.
Margin models at clearing venues, which size a requirement per contract from recent volatility.
Volatility-targeted pools, whose exposure is a division rather than a decision.
Risk limits stated as a loss at a confidence level, which is lesson 18's calculation with a cap attached.
Eligibility screens carrying volatility ceilings, which can remove a holding from a permitted list entirely.
Mandates capping how far a holding may deviate from a stated benchmark, which tightens as volatility rises.

Take the arithmetic of one of them. A margin requirement per contract of the form multiple times daily volatility times notional, with an illustrative $232,000 notional and a 3.2 multiple. At 18 percent annualised volatility the daily figure is 1.1339 percent and the requirement is $8,418.02. At 39 percent it is 2.4568 percent and $18,239.05 — 2.1667 times as much.

Now apply a fixed pool of capital. With $250,000 available, the first requirement supports 250,000 ÷ 8,418.02 = 29.70 contracts, so 29 after rounding down, and the second supports 13.71, so 13. Notional falls from $6,728,000 to $3,016,000. That is $3,712,000 sold, or 55.17 percent of the position, with nobody forming a view.

The point is not that any one of these rules is unreasonable. Each is a sensible response to a rise in measured risk. The point is that none of them knows about the others, all of them read approximately the same number, and each one's response supplies the price movement that the next one's input is computed from. That is why a single volatility print can move a haircut, a margin requirement, a fund's exposure and a screening decision inside one session.

Key terms

Margin model: The arithmetic that sets how much must be posted per contract. Typically a multiple of recent daily volatility times the contract's notional value.
Common input: One statistic consumed by many unconnected rules. It is what synchronises otherwise independent reactions across a market.
Rule-based reduction: A fall in position size produced by a requirement rather than a choice. It is often a whole-number reduction, so it arrives in jumps rather than smoothly.

Worked example

A margin model, and 55 percent of a position

An illustrative contract with $232,000 of notional, a margin multiple of 3.2, and $250,000 of capital available. Only volatility changes.

Volatility 18%: Margin $8,418.02
Contracts supported: 29
Volatility 39%: Margin $18,239.05
Contracts supported: 13
Notional before and after: $6,728,000 and $3,016,000
Amount reduced: $3,712,000, or 55.17%

The margin requirement rose 2.17 times and the position fell by more than half, because capital was fixed and the requirement was not.

Check yourself

A margin model charges 3.2 times daily volatility times a $232,000 notional. Volatility rises from 18 percent to 39 percent and capital is fixed at $250,000. What happens to the position?

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.