On NASDAQ volatility. On NASDAQ volatility
Tags: Finance, Data Science, Investing, Technology, Stock Market

On NASDAQ volatility

Photo by charles Lebegue on Unsplash

In a previous article, we looked at the analysis of NASDAQ trend, to see what kind of exponential growth would fit the NASDAQ trajectory. And after looking at the growth, we came up with a single number to describe the NASDAQ trajectory over the last decade. In this article we are going to put the volatility under spotlight. And to examine, how can volatility help to amplify (or stunt) the returns. What kind of strategy will be optimal for tackling volatility.

Decade long trend

While looking at NASDAQ and fitting an exponential curve to it, rising every quarter, we came up with a figure like one below. This describes the evolutionary path of NASDAQ separated into quarters.

QQQ index with a 3.75% a quarter, growth line

On top of the QQQ (NASDAQ ETF) index line (in blue), we plot the representative level in each quarter (orange line) and a fixed, exponentially incrementing line growing at 3.75% a quarter (green). Assumption is a starting investment of 100K dollars.

Picturing volatility

As we pointed out in the earlier article, this trend fits the NASDAQ trajectory almost perfectly in the last 10 years. And possibly alludes to the growth of technology sector within a broader economy. Now, we want to look at the volatility. In other words, what were the variations around this trend. To get that is simple enough. We subtract the trend, from the index representation. In other words, we subtract the orange line (index at a point in time) from the green line (fixed compounding line). We show the result below.

QQQ with fixed growth and variations around it

As we see the red line representing variations around the trend, bouncing from zero to positive to negative in its history. This is good. It tells us that the red line has the characteristics of randomness. A kind of meandering up and down. So now we know, that we have visualized, what would have been random variations in the index, triggered by the news cycle, random events, business adjustments, macroeconomic interventions etc.

Notice the two features of the red line. One, it goes up and down as already pointed above. Two, the up and down variation of it is expanding. Or in other words, the variations increase, as we move out from the initial investment time (2010) towards the current investment time (2020). This is to be expected. Because the initial investment has increased six fold in value, we should expect the variations on it to have increased too ? But how can we put these variations in context. In a context where they can be useful.

Harnessing volatility

Volatility implies variations around the underlying trend. Since the trend is on the up, the variations also increase. The fundamental investing premise is to buy low and sell high. How does volatility inform or can help us realize this premise. Volatility is telling us when we are under (negative) versus over (positive) the trend. If we buy when we are under, and sell, when we are over, we would have harnessed volatility to realize the golden investment objective, harped on by all the investing legends of the past, present, and of the future(possibly !!!).

The next big question then is, how can we have the capital available, to make this volatility signal, our friend. Selling is obviously easy. You don't need money to sell something. Buying though is not. You need capital to buy. How can we make sure, that we have the capital to buy when the volatility signals us to buy. This is where we can put some trends around volatility to understand the character of it. What would be the idea characteristic to describe volatility. One answer to that, is to describe it in terms of the underlying capital !! In other words, what proportion of capital should I have saved, to be able to play volatility to my advantage. This is what we do next. On top of the volatility line, I plot the positive and the negative percentage lines. This percentage, is percentage of the fixed growth line. The idea being that fixed growth line represents (on an average) where we are in terms of our capital accumulation. We begin by allocating just 5% of the invested capital as a volatility capturing reserve fund. Here is the result from doing that.

Volatility with +/- 5% of invested capital boundaries

We have plotted the +5% of capital as well as -5% of capital line. Remembering that volatility is both positive and negative. As we observe, the red line goes in and out of these bounds. Meaning the amount of capital reserved, would be insufficient at times, to completely buy the volatility induced signal. It can still work in most part, since we don't need to do ‘buy low sell high’ perfectly to gain from it. We can always gain from it to the extent possible. But just for the sake of optimization, lets see if we can bound the volatility signal better. Next, we stretch the bounds a little to 10% of invested capital (in green trend line). Here is the result.

Volatility with 10% of invested capital bounds

We seems to have improved. Red, now mostly stays within the bounds, only transgressing occasionally. The most glaring exception is towards the end of 2020, where the red is broadly outside the bounds of 10% variation. This can speak to the historical over-valuation of NASDAQ, as we pointed out in an earlier article. Or, it might signal the start of a new volatility era. No one knows for sure. However, the best we can reason is, that 10% volatility is what has characterized NASDAQ quite well, over the last decade. To be absolutely safe, we could have reserved 15% of the invested capital as a safety fund for this investment vehicle, to make use of ‘buy low sell high’ paradigm.

Final thoughts

The volatility paradigm is not an exact science. In general, the volatility trends do behave like well-characterizable random up and down on a certain investment vehicle. But occasionally there are outliers too. Commonly referred to as Black Swans. We can imagine the current overvaluation of NASDAQ to be an outlier event, that will go away and the volatility will come back to its original bounds. The figure below shows that reserving 30% of capital in the reserve fund would be enough to cover the current overvaluation (black swan ?) and possibly make use of an adjustment (towards the negative Black swan) in the future.

Volatility with 30% of the capital bounds

With 30% of invested capital bounds, our volatility line lives well within the bounds. We have alluded to the ‘buy low sell high’ paradigm, as being enabled by looking at volatility in this way. Ideally you would lighten you market fund allocation, if you go too far above the trend line, and load up on allocation, if you spring below the line. There can be many different strategies to actuate this dynamic. We leave it to readers imagination in this article, with more analytical approaches and their results to be discussed in a later article.

A near-perfect growth of close to 3.75%-a-quarter for the last decade, and a volatility that remains bounded to within approximately 15% of the invested capital. This has been NASDAQ over the last decade. With the future being created right in front of our eyes, we are keeping our fingers crossed on what comes next.