Volatility targeting is a portfolio management tool aimed at managing portfolio risk by targeting a particular volatility level and adjusting the positioning of the portfolio in an attempt to stay close to the volatility target. Although it is possible to implement volatility targeting with any asset, portfolios of derivatives provide a cost-effective implementation as trading is often done on a daily basis.

Following the research of Moreira and Muir (2017) the idea is very straightforward; one needs to simply scale asset weights in the portfolio by the ratio of the target volatility and the expectation of future volatility given the current asset mix. Obviously, the value of the targeting is greatly impacted by the quality of the volatility expectation model, but since these estimates are over short horizons, the fact that volatility tends to cluster² makes this an “easier” effort. In equation form, the return of the volatility managed portfolio, is the volatility scaled return of the unmanaged portfolio which is simply the sum product of the asset weights and their returns.³ When expected volatility is below target, the portfolio should lever above 100% and vice versa if the target to expected volatility ratio is less than 1⁴.