VIX-based Pairs Trading (Market Neutral) Strategy
This post was inspired by CSS’s VIX as Moderator of Small vs Large Cap Performance.
In a nutshell, when the VIX (CBOE volatility index) is “relatively” high/low, large caps tend to outperform/underperform small caps. I’m going to spin CSS’s observation into a market neutral pairs trading strategy between the S&P 500 (large caps) and the Russell 2000 (small caps).
The graph above shows the results of this pairs trading strategy (red) versus the S&P 500 (grey) from 1989.
Because there’s so little day-to-day deviation between the S&P 500 and Russell 2000, we’re using leverage to juice returns. Specifically, I’m assuming the strategy was applied to ProFunds/Rydex 2X leveraged mutual funds (my weapon of choice), so we can ignore transaction costs and slippage.
Strategy rules: if the VIX will close at least 5% higher than the 63-day (1 quarter) moving average of the VIX at today’s close, go long the S&P 500 and short the Russell 2000 at the close. If the VIX will close at least 5% lower than the 63-day average, reverse the pair and go long the Russell 2000 and short the S&P 500 at the close. If the VIX will close within this 5% band, the pair is unpredictable so move to cash.
One last bit of slickness: the S&P 500 and Russell 2000 are not equally volatile. At this moment in history for example, the Russell 2000 is about a third more volatile than the S&P 500. If we allocated the portfolio 50/50%, we’d lose market neutrality. So instead, we’ve weighted each leg in the pair to balance expected volatility.
Numbers for the number lovers…
The strategy has not been particularly potent generating return, but most market neutral approaches aren’t.
The benefit of this type of strategy is extremely low volatility (about 40% less than the S&P 500) and high returns relative to that volatility. I especially like that this strategy trades very frequently yet performance has stayed consistent through very different market regimes.
A Word on Execution
The success or failure of all strategies depends on the specific vehicle being traded. A strategy may work very differently on an asset that tracks an index closely (ex. leveraged mutual funds) than on an asset with significant tracking error (ex. ETFs).
This is less of an issue with longer-term strategies (ex. the Golden Cross) than with shorter-term ones (ex. RSI(2)) because they tend not to rely on such small trading advantages. But this is a GINORMOUS issue for this pairs trading strategy because it is so sensitive to minute differences in price.
Because leveraged mutual funds haven’t been around as long as this test, I simulated daily returns based on the underlying indexes. We can do this because these funds track their benchmarks so tightly, but note that I’ve also tested the strategy directly on the fund data that was available and (surprisingly) achieved slightly better results.
So I’m confident we could achieve these returns on this specific asset, but (and this is a huge BUT), I would not assume these results hold true for any other trading vehicle.
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Filed under: Trading Strategies, VIX & Volatility | 29 Comments