Profitable ETF Trading Strategies: understanding ETF volatility
There are many different useful definitions of the concept of volatility. For the purposes of this essay I just want to consider volatility in a non-technical way, and that is as the amount of variation in returns around the mean, or the average.
In any bundle of returns from a trading system, you will always be able to calculate the average return. If most of the returns are tightly clustered around the average you would normally consider this to be predictable and reliable and low volatility. If individual returns were widely scattered above and below the average, you would normally consider this to be unreliable, risky and high volatility.
That is the general sense of volatility that I want to consider in this essay.
Now, I want to consider some lessons learned concerning volatility in exchange traded funds within your trading practice.
ETFs are much less volatile than individual large cap stocks. This is true even for ETFs whose components holdings are all large cap stocks. Even the big, mature companies in the Dow Jones Industrial 30 index are much more volatile than the composite ETF that holds them. This is ETF trading symbol DIA.
One of the things you get with lower volatility ETFs is the ability to engineer your position sizes more carefully because ETFs have less volatility and also tend to be more range bound. You are much more likely to have an extraordinary event in individual stock which includes the possibility of a runaway winner whereas ETFs are more likely to give you long regular cyclic waves of winners and losers.
In addition to ETFs having lower average volatility, they also have a lower standard deviation in general than the individual stocks that make up the index. What this means is that the amount of surprise you are subject to is generally less on both the upside and downside. This is true regardless of whether you’re ETF is focusing on shore conservative companies were smaller cap growth.
Of course we want to be careful in overestimating the usefulness of this information. We want to remember that even low volatility ETFs Possibility of large at first moves off of overnight surprise news.
So ETFs may isolate you from some individual company risk but at the cost of giving up the opportunity for wildly explosive moves in your favor by surprise. For many traders, this is an excellent trade-off if you are looking for regular normal returns.