How to simplify risk management, asset allocation and options trading through volatility and GARCH forecasting
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A number of you have asked me to briefly explain quant algos and ideas at a basic level so you can understand their benefits more clearly. I’m happy to accommodate you. I enjoy teaching, and this also gives me the opportunity to demonstrate why a Quantlabs.net Premium membership is an exceptional value for you.
Today’s topic is about forecasting volatility. There are 3 main reasons you’d want to do this: risk management, asset allocation, and options speculation.
1. You can’t manage risk without an accurate measure of potential losses which themselves are based on future volatilities and their correlations.
2. Assets can’t be allocated sensibly without minimizing risk relative to expected return — again, you need an accurate way to estimate the variance-covariance matrix.
3. As for options trading, you’re no doubt well aware that options prices are highly correlated to volatility.
Now GARCH (Generalized Auto Regressive Conditional Heteroskedactic) is all about predicting future volatility. It models data series that exhibit periods of crazy swings followed by periods of relative calm, which is exactly what interests us as traders. Key ideas behind GARCH modeling:
* If an asset price made a big move yesterday, it’s more likely to make a big move again today
* Volatility not only spikes during crises, but it eventually drops back to approximately the same level of volatility as before
* Graphs of post-crisis volatility exhibit kurtosis (fatter tails) before they drop back to “normal” levels
The various iterations of GARCH capture all these points and more with complex equations forming each model.
And the good news is that, I cover GARCH in-depth in my Algorithm, Modelling, and Strategy Development course. It’s one of the many, many tools for which I provide the source code in R, tutorial videos, and everything you need to know to use it correctly and profitably.
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P.S. Risk management and asset allocation are key principles for any serious quant trader. And if you’re interested in any kind of options trading — many quant traders are! — GARCH’s volatility forecasting is absolutely essential.
I’m also providing source code for pairs trading, cointegration, estimating, simulation, and much more. It’s all coming ASAP!FACEBOOK ACCOUNT and TWITTER. Don't worry as I don't post stupid cat videos or what I eat!