Strategy #2 for Trading Volatility ETPs: Timing the VIX
As I’ve shown before, timing the VIX index itself is easy (albeit useless):
In the graph above I’ve assumed we could buy/short the VIX index at the close when the 10-day EMA of the VIX closed under/over the 10-day SMA. An EMA is a faster moving average than an SMA, so this is a mean-reversion strategy.
The graph shows that the VIX is uber predictable.
The problem of course is that back here in the real world the VIX futures term-structure acts as such a strong head/tailwind on volatility ETPs that it effectively becomes the most important driver of returns, not movements in the VIX itself.
But what if we traded these ETPs by timing the VIX, but only taking those trades where the term-structure put the trade in our favor?
Go long VXX/XIV at the close when the 10-day EMA of the VIX closed under/over the 10-day SMA, AND the average daily impact of the term-structure was greater/less than zero, otherwise move to cash.
See this post for more on estimating the average daily impact of the term-structure. Strategy results from 06/2004 (frictionless):
Despite its simplicity, this strategy would have put up impressive numbers: a 53% annualized return with less than 1 trade per week and a max drawdown of -33%.
Like the strategy I presented in my last post, there’s clearly some low hanging fruit to improve on these results (like stop losses), but the smoothness of the equity curve through very different volatility regimes demonstrates nicely that timing the VIX while respecting the VIX futures term-structure is an effective strategy.
As I talked about previously, I use a mix of both types of strategies.
Following the term-structure (ex. strategy #1) ensures I always have some exposure to which way the winds of the VIX futures term-structure are blowing. And timing the VIX (strategy #2) tells me when the market is particularly ripe for a trade so that I can up my risk exposure.
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Filed under: Trading Strategies, VIX & Volatility | 16 Comments