A Critique of TradingMarkets.com’s VXX/XIV Strategy
This is a follow up to TradingMarkets’ A Low Volatility Strategy for Trading High Volatility (h/t The Whole Street) in which they describe a strategy for trading vol-ETFs VXX/XIV based on mean-reversion and the short-term indicator RSI(2).
Results of TradingMarkets’ strategy from 02/2009 – 05/2012.
TM’s strategy: Divide portfolio into 6 units. Buy 1 unit at the close when RSI(2) of VXX closes above 90. Add 2 additional units if VXX closes above your entry price at any point. Add a final 3 units if VXX closes above your second entry price at any point. Close all positions when RSI(2) closes below 50. TM’s post assumes we shorted VXX, but this is unreliable in the real-world, so I’ve assumed that we instead went long the inverse ETF XIV.
Note uber-sexy results. TM says, they’ve “never seen numbers like this in equity trading.”
One BIG problem: TM’s strategy aggressively adds to the original position as the market moves against the trader, repeatedly doubling-down on a bad entry. That’s fine for well-behaving markets, but how would this approach have fared during times of real market stress, like 2008?
Luckily, readers know that we can estimate VXX/XIV returns with pretty darn good accuracy all the way back to 2004 (read more), so below I’ve shown the same strategy starting in 03/2004:
Not nearly as impressive. Only a 9.2% annualized return with a whopping -32% max drawdown during the 2008 crises. Not a horrible result, but not the Madoff’esque numbers the initial test would imply.
This revised test demonstrates the weakness of this type of extreme overbought/oversold strategy. It works great until it doesn’t, and then it lops off your head. That’s especially true when trading vehicles like VXX/XIV that can move so far in such a short span of time.
Further, the strategy ignores an important characteristic of VXX/XIV: the always important impact of the VIX futures term-structure (but that’s a subject for another post).
IMHO, this strategy is a dangerous one. Extreme OB/OS strategies, that might be appropriate for equity indices or even individual stocks, are not appropriate for portfolio killers like VXX/XIV.
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Filed under: Trading Strategies, VIX & Volatility | 12 Comments