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Finally, Damian from over at Skill Analytics reminded me that traders can get hit with larger than expected losses when using ATR stops. This would occur when volatility has died down, which would cause the ATR stop to get tighter and tighter. If a system is using a percent-risk formula for position-sizing, as the stop gets tigher, it is buying bigger and bigger positions. If volatility suddenly returns, the system may experience some large losses, until the ATR stop has time to catch up with the market volatility.
According to Asness and Berger, quant managers often target constant volatility not constant dollar exposure. As a result, they lever up in times of low market volatility and lever down in times of higher volatility. The problem last August, they say, was that many quant managers were using higher leverage than usual at that point in the cycle. As a result, a pure Fama/French model with no leverage would have actually performed much better that month than most quants.
It’s important to note that they are talking about using volatility not as a stop in this case, but as a way of judging how much leverage one should have. This is why I believe you need to have minimums in volatility-based position sizing to insure that in low-vol environments you don’t get taken out on a stretcher. So it is rather shocking that these guys would let volatility alone determine the amount of leverage. The fact that these guys overused leverage, however, isn’t really all that shocking – it is the opinion of this writer that many hedge funds are selling alpha while delivering nothing more than beta * leverage.