Does the VIX index have predictive power

Trading Volatility: Better Predictable Than Stock Market Returns

In the past, you could only invest in volatility through options, futures, or swaps. However, the ETF boom did not end here either, which is why there are now ETFs and Exchange Traded Notes (ETNs) that simplify the trading of volatility for private investors. The aim of Tony Cooper's paper is to develop a trading strategy with ETFs or ETNs based on volatilities. The authors are convinced of the advantages of volatility investing and recommend replacing the classic 60% stocks / 40% bonds portfolio with 55% stocks / 35% bonds and 10% volatility. Volatility is thus discussed as an additional asset class.

Easy volatility investing
Tony Cooper
Double-digit numerics

Link to the paper: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2255327

 

The authors base their strategies on the following assumptions:

1) In contrast to the stock market return, the volatilities are predictable

2) Changes in volatilities are negatively correlated with share prices

3) Investors are willing to pay a premium to reduce volatility (Volatility Risk Premium)

The following graphic shows the capital development of a simple mean reversion strategy on the VIX volatility index. Here you go long the index when it falls below the simple 11-day moving average and otherwise stay short. The author uses the median instead of the mean for all averages, as this offers better predictive power. With an annual return of 215% since 1990, the strategy has been incredibly successful. The basis of the strategy is based on the fact that historically extreme values ​​tended to be followed by normal values ​​and thus a mean reversion is present.

The VIX itself is not tradable as an index. The author therefore uses the following 4 ETNs for the strategies presented. These differ in terms of duration (short, medium) and direction (long, short):

Here are the results of the individual strategies, which are explained below. The period of the investigation is from 2004 to 2013. The 5th strategy is very complicated and addressed to ETN issuers, so I have left it out here:

The following graphic shows the enormous capital development of the strategies. The investigation period was divided into 5 different phases in order to characterize the different trends.

 

1. Strategy - Buy and Hold

The first strategy is a pure buy and hold of the XIV (short). In addition to the lower return compared to the other strategies, the main disadvantage here is the risk, which is also expressed in the maximum drawdown of 92.6%.

2. Strategy - Momentum

This strategy takes advantage of the momentum effect. According to the founder of the efficiency market hypothesis Eugene Fama, this is “the primary anomaly” and has been proven in various studies in all asset classes. For the strategy, you compare the current price of the 4 ETNs with the respective price 83 days ago and then invest in the ETN with the highest price increase. The 83 days are optimized here, but the authors found good results for all periods around this area.

This strategy has several advantages:

- It is based on an empirically proven anomaly (momentum)

- The maximum drawdown is relatively low at 43%.

- There is a negative correlation to the S&P 500!

3. Strategy - Roll Yield

This strategy aims to take advantage of the profits from rolling the ETN's futures. Here, the prices of volatility indices are used to determine whether there is contango or backwardation (CoB) in the market. For this purpose, the price of the VIX is compared with the VXV. The VIX is a measure of the expected S&P 500 volatility for the next year, while the VXV determines the expected volatility for the next 3 months. The strategy accordingly invests in the XIV (short) if VXV (3M)> = VIX (12M) and in the VXX (long) if VXV (3M)

4. Strategy - Volatility Risk Premium

The idea is to either go long or short, depending on whether there is a positive or negative volatility premium. The current VIX minus the historical volatility of the last 10 days is calculated. A 5-day moving average is also used to calculate historical volatility. If this value is greater than 0, investments are made in the XIV (short) and otherwise in the VXX (long).

Finally, it should be mentioned that the volatility ETNs are very risky and were actually designed for day trading. It is therefore important to be well informed about how these work in order to avoid large losses.

Conclusion

In the past, you could successfully trade volatility using simple strategies. The Momentum strategy offers a simple implementation. This relies on the volatility moving in trends and thus represents a classic trend following strategy. The greatest advantage here is a negative correlation to the S&P 500. The strategy is therefore suitable as an extension to an equity portfolio. All strategies have been able to deliver phenomenal results in the past, but have been over-optimized in some cases. It is also important to remember that the strategies with a standard deviation of over 50% are extremely volatile.

planning: We are implementing a volatility-based trading strategy in the system trading room in 2018.