by Trading the Odds
The majority of readers will already be familiar with the fact that the CBOE Volatility Index® (VIX®) is not a tradable asset (it is just a number), and trading the VIX® in fact means trading its derivatives (futures) or even derivatives of derivatives (options on futures, ETFs/ETNs like XIV® – VelocityShares Daily Inverse VIX Short-Term ETN – and VXX – iPath® S&P 500 VIX Short-Term Futures™ ETN – ).
Due the mean reverting nature of the VIX® (e.g. when bottoming out in the 10-12 range, a sudden spike is much more likely than a further drop, and conversly after a sudden spike to extended levels, a (quick) drop and/or slow decrease to regular levels is just a question of time and much more likely than a further rise), timing and trading the VIX® would of course be much easier than timing and trading its derivatives (and derivatives of derivatives) where one has to take into account (and overcome) time to maturity (futures, options), time decay, risk premium (futures, options, ETFs/ETNs), roll yield (ETFs/ETNs), term structure (contango/backwardation of futures), seasonalities (e.g. FED announcement days, the last days before maturity, …), among others.
Some time ago MarketSci published an intersting article about timing (and trading) the VIX® ( Random Thoughts RE: Trading Volatility ETFs (Part 1) ), utilizing a 10-day EMA (Exponential Moving Average) and a 10-day SMA (Simple Moving Average), going long (selling short) the VIX® index at the close when the 10-day EMA of the VIX® closed under (over) the 10-day SMA. Expectably (selling short an asset which is always bottoming out in the 10 – 12 range) – in contrast to going long the XIV® (selling short volatility) – the short side of the trade was more or less treading water over the course of the time frame under review (since 1990) while the long side went straight up (low risk / high reward).
But as previously shown, with respect to a highly volatile asset like the VIX® , a 10-day moving average – even an EMA – is disadvantageous compared to a shorter-term moving average. And additionally – at least with respect to trading the Volatility Risk Premium Strategy – utilizing the CBOE Mid-Term Volatility Index ( VXMT® ) as a the repective trigger index instead of the VIX® may have some benefits again as well.
To make a long story short:
Image I shows the respective equity curves:
(1) VIX® with 10d EMA vs. 10d SMA: blue line (complies to MarketSci’s posting)
(2) VIX® with 3d EMA vs. 10d SMA: grey line
(3) VIX® before 1/1/2008 , VXMT® after 1/1/2008 with 3d EMA vs. 10d SMA: red line
(4) 120% of VIX® | -20% of VXMT® with 3d EMA vs. 10d SMA: black line
* just VIX® before 1/1/2008 , VXMT® after 1/1/2008
(5) 120% of VIX® | -20% of (VIX® + 10%) with 3d EMA vs. 10d SMA: green line
* before 1/1/2008, VIX® had been increased by 10% in order to replicate the VXMT®
Image I – Total Equity Curve(s)
(01/01/1990 – present)
Some remarks are mandatory:
(1) Any additions/changes in the respective underlying are only related to the exponential moving average ( e.g. 120% of VIX® | -20% of VXMT® ). The 10-day SMA remains unchanged and is always based on the VIX® index.
(2) The blue line represents MarketSci’s 10-day EMA | 10-day SMA mean reversion strategy. The respective performance (hypothetically trading the VIX®) could’ve been easily boosted by utilizing a 3-day EMA instead of a 10-day EMA ( grey line ). Simply replacing the VIX® by the VXMT® index ( red line ) would be very disadvantageous (a least with respect to a mean reverting strategy) due to the fact that the VXMT® is regularly trading (significantly) above the VIX® index ( contango ). Even better works a mixture of 120% VIX® minus 20% of VXMT® , regularly (artificially) reducing the index value ( black line ).
(3) This very simple mean reversion strategy works best when applying this kind of ‘mixture’ right from the start, means first of all simulating VXMT® index values in the simplest way by adding a constant 10% premium to VIX® index values before VXMT® index values are available (1/1/2008), and secondly applying the previously mentioned formula again ( 120% of VIX® | -20% of (VIX® + 10%).
Image II shows the respective equity curves (long / short seperately) for MarketSci’s 10-day EMA | 10-day SMA (black / grey) and the 120% of VIX® | -20% of (VIX® + 10%) with 3d EMA vs. 10d SMA (green line) mean reversion strategy.
Image II – Total Equity Curve(s)
(01/01/1990 – present)
And last but not least – probably surprising the most – the respective Summation Index, simply representing the running total of net advances = raw quality of forecast (getting an index move right: +1 ; getting it wrong: -1). This image clearly shows that trading is NOT about being right or wrong (means just getting the direction of the move right), but all about making money (effectiviness and efficiency). MarketSci’s 10-day EMA | 10-day SMA (blue line) and the 120% of VIX® | -20% of (VIX® + 10%) with 3d EMA vs. 10d SMA (green line) mean reversion strategy are at equal level (at the end of the field !), but the latter strategy is doing things in an optimal way, being right when the VIX® index moves big and losing small when being wrong (it ouperforms the 10-day EMA | 10-day SMA strategy by a factor of 1E+8) while the “VIX® before 1/1/2008 , VXMT® after 1/1/2008 with 3d EMA vs. 10d SMA” ( red line ) is at the top of the pack even after 1/1/2008, unfortunately winning small and losing big, depleting its net asset value since 1/1/2008 by 99.9%.
Image III – Summation Index
(01/01/1990 – 10/15/2014)
But how to take advantage of these findings will be subject to another posting. And may be some food for thought for your own analysis as well.