Volatility
Standard deviation of returns; the standard measure of dispersion and risk in backtesting.
Definition
Volatility is typically the standard deviation of period returns (e.g. daily or monthly). Annualized volatility = σ_period × √(periods per year). It measures the dispersion of returns around the mean.
Why it matters for backtesting
- Risk scale: Central to Sharpe, position sizing, and vol-targeting.
- Comparability: Normalizing by vol (e.g. vol-targeting) makes backtests comparable across strategies and regimes.
- Realism: Backtests that ignore vol or use unrealistic leverage can produce misleading results.
Limitations
- Symmetric; does not distinguish upside vs downside (see Sortino).
- Assumes stationarity; vol regimes change.
- Sensitive to the window length and the return frequency used.
Linked concepts
Sharpe ratio, vol targeting, beta, Sortino ratio.