Utilizing Volatility Benchmarks In Building Long-short Stock Pairs

Applying volatility benchmarks correctly is the key to effective portfolio management. This article explains how volatility and VaR (Value at Risk) is utilized in a market neutral, long-short, volatility-based strategy to yield the most predictable and stable alpha.

To apply volatility correctly, investors must identify a relatively stable stock first, which is the key task before opening long-short positions. There are several various metrics and methods used for determining a relatively stable stock. We use an estimate based on 99% VAR (Value at Risk).

According to Investopedia's definition, Value at Risk (VaR) is a statistical measure that quantifies the extent of possible financial losses within a firm, portfolio, or position over a specific time frame. This metric is most used to determine the extent and probabilities of potential losses in their institutional portfolios. Risk managers use VaR to measure and control the level of risk exposure.

VaR is calculated as = [Expected Weighted Return of the Portfolio − (z-score of the confidence interval × standard deviation of the portfolio) × portfolio value

The most important metrics in calculating VaR estimate for every particular security are the calculated VAR values or quantiles of the threshold range of 95% or 99% VAR.

The smaller the dispersion of the security’s closing price within VaR limits and the lower the quantity and VaR tail values, then the more stable is the stock.

We can use this security in the future for calculating volatility and threshold deviations from volatility based on normal, or in some more complex cases, abnormal distribution models.