The Auto-Pilot: Volatility Targeting (Vol Control)
The Auto-Pilot: Volatility Targeting (Vol Control)
Why hold 100% equities when the market is screaming “Danger”? How to systematically reduce exposure when volatility spikes and leverage up when it’s calm.
Executive Summary
- The Phenomenon (Clustering): Volatility is not random; it clusters. If today is volatile, tomorrow is likely to be volatile too. Market crashes rarely happen out of the blue; they are preceded by a period of rising volatility.
- The Mechanism: You set a “Target Volatility” (e.g., 12%).
If current Vol is 6% (Calm) 👉 Leverage up to 200% exposure.
If current Vol is 24% (Panic) 👉 Cut exposure to 50%.
Result: You make more money in bull markets and lose less in bear markets. - Sharpe Ratio Hack: By keeping the portfolio’s risk constant (instead of letting it fluctuate wildly with the market), you mathematically maximize the Sharpe Ratio. This is the engine behind many Risk Parity funds.
The Flash Crash Risk
Vol Targeting works best in slow-moving crises (like 2008). In a Flash Crash (like 1987 or Covid 2020), where the market drops 20% in a few days before volatility signals can register, this strategy reacts too late. It is not a replacement for Tail Risk Hedging (Put Options).
Mechanic: The Inverse Exposure Rule
Low Vol
Max Leverage
High Vol
De-risk (Cash)
Constant
Risk Budget
Systematic
No Emotions
Simulation: 2008 Financial Crisis (Passive vs. Vol Target)
Drawdown Management
| Feature | Static Allocation (60/40) | Dynamic Allocation (Vol Target) |
|---|---|---|
| Exposure | Fixed (Always 60% Stocks) | Variable (20% to 150%) |
| Risk Level | Fluctuates wildly | Constant (Targeted) |
| Input Signal | None (Ignore market) | Realized Volatility / VIX |
“In investing, speed kills. Volatility Targeting is simply a speedometer that slows the car down when the road gets curvy and speeds up when the road is straight.”
Essential Resources
INTERNAL
BMT Playbooks