Trading the Odds’ Optimized VRP Strategy

This is a test of another “Volatility Risk Premium” (VRP) strategy from the always excellent Trading the Odds (1). The strategy is similar to the Brute Force VRP, DDN’s VRP, and original TTO’s VRP strategies that we’ve shared previously in that it compares implied and historical volatility to predict changes in VIX ETPs like XIV and VXX.

See footnote re: the difference between my results and those produced by TTO (2).

Below are the results of TTO’s strategy in blue trading XIV and VXX from 07/2004 to present, versus buying & holding XIV in grey. Read about test assumptions, or get help following this strategy.

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Strategy rules:

  • At the close, calculate the following: the 5-day exponential moving average of [30-day constant maturity price of VIX futures – (2-day historical volatility of SPY * 100)].
  • Go long XIV at the close when the result of the above formula is greater than 1, otherwise go long VXX. Hold until a change in position.

Note the differences between this strategy and other “VRP” strategies we’ve tested: (1) this strategy uses the 30-day constant maturity price of VIX futures (as opposed to the VIX) as a measure of implied volatility, and (2) it smooths the signal with a more responsive exponential (as opposed to simple) moving average.

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While this strategy would have performed better historically than any of the other VRP variations we’ve tested, I remain more or less equally confident in its ability to perform in the future out-of-sample.

Call it the cynic in me, born out of years of deploying strategies here in the real world, but I am much more interested in concepts than specific parameter selection – the concept here being comparing implied and historical volatility.

You’ll find that the fortunes of these concepts tend to rise or fall together. This month is a good example, with this entire class of strategies struggling as a result of the dichotomy discussed here.

Why does this concept work? Because historically, when implied vol as fallen too far below historical vol, it has often meant implied vol is underestimating future realized vol, which over time will put pressure on the VIX and VIX futures to rise, and ETPs like XIV and ZIV to fall.

One final note…

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In the results above, I’ve compared the strategy as originally tested to trading XIV-only (and moving to cash instead of VXX). Notice the significant decline in performance, especially in terms of risk-adjusted performance (Sharpe and UPI). Note too how the strategy would have spent a mere 11% of all days long VXX (and most of those days were bunched together in brief periods such as 2007/08).

When such a small percentage of the total sample contributes such a large percentage of performance, it exponentially increases the risk of overfitting (which leads to failure to perform out-of-sample).

That’s true not just for this strategy, that’s true for all of these long/short volatility strategies (including ours) that are heavily biased towards the inverse VIX play, but rely on major VIX pops to boost historical returns. Whether these strategies will be able to so deftly capitalize on those major VIX pops in the future is suspect.

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A big thank you to Trading the Odds for the thoughts and allowing us to add our two cents here.

When the strategies that we cover on our blog (including this one) signal new trades, we include an alert on the daily report sent to subscribers. This is completely unrelated to our own strategy’s signal; it just serves to add a little color to the daily report and allows subscribers to see what other quantitative strategies are saying about the market.

Click to see Volatility Made Simple’s own elegant solution to the VIX ETP puzzle.

Good Trading,
Volatility Made Simple


Wonk notes:

  • These type of strategies, comparing implied and historical volatility, have become known as “volatility risk premium” or VRP strategies. In truth, there are multiple VRPs in the VIX complex (VIX spot vs realized volatility, VIX futures vs realized VIX, etc.), so admittedly, the term is probably not the most accurate. In any case, we stick with that convention here.
  • The results of our tests are worse than those presented by TTO. The biggest reason is that TTO uses the S&P 500 cash index (GSPC), while I use the non-dividend adjusted S&P 500 ETF SPY, to calculate historical volatility. I can find no empirically-sound reason why using one index in place of the other should lead to such starkly different results, so I chalk most of the performance difference up to overfitting. That isn’t intended as a gotcha, as all backtests are inherently overfit to some degree. And it isn’t to say that GSPC or SPY is better or worse than the other. It’s only to say that if I were to use GSPC here, the sole purpose would be to produce a better looking backtest, so I’m sticking with the convention that I’ve used historically on this blog.

An Interesting Dichotomy is Shaping Up in the VIX Complex

An interesting dichotomy is shaping up in the VIX complex.

On one hand, the premium between VIX futures (30-day constant maturity) and the VIX spot stands at its highest level in more than 2 ½ years. That’s generally been a good thing for the inverse VIX play (ex. short VXX or long XIV), because historically it’s meant VIX futures were overpriced (as opposed to the spot being under-“priced”), which has over time put pressure on futures to fall.

Some strategies that take advantage of this observation: Macro Investor’s Strategy, DFTB’s Spread Strategy, and Evolution Capital’s Strategy.

On the other hand, the VIX spot is selling at significant discount to historical vol. That’s generally been a bad thing for the inverse VIX play, because historically it’s meant the VIX is underestimating future realized volatility, which has over time put pressure on the VIX (and VIX futures) to rise.

Some strategies that take advantage of this observation: Brute Force Optimized VRP, TTO’s VRP, and DDN’s VRP

You can see historicals on all of these relationships in our post Four Graphs to Rule Them All.

There are of course multiple ways to measure historical volatility, but using what’s probably the most commonly cited in this context: the 10-day annualized std. dev. of the S&P 500, there have only been two previous instances where the premium between VIX futures and the spot was as high as it is today, and at the same time, the discount between the spot and historical vol was as low.

The first was in late-2011 and the second in mid-2012. In both instances, like today, the VIX was falling following a recent spike. And in both instances, VIX futures were lower (and XIV/ZIV higher) a week and month later.

What do these two incidents say about the current state of the VIX complex? Likely nothing. Two observations do not a robust conclusion make.

But the current dichotomy in the VIX complex will be interesting to watch in the coming week(s). My best guess is that the premium between futures and the spot wins the day, XIV/ZIV falls, and we find that all of those measures showing elevated historical vol were based on fears that are no longer a factor (ex. our most recent FRB meet).

Click to see Volatility Made Simple’s own elegant solution to the VIX ETP puzzle.

Good Trading,
Volatility Made Simple

VIX Trading Strategies in February

We’ve tested 22 simple strategies for trading VIX ETPs on this blog (separate and unrelated to our own strategy). And while I can’t speak for all traders, based on all of my readings both academic and in the blogosphere, the strategies we’ve tested are broadly representative of how the vast majority of traders are timing these products.

Some of these strategies returned in excess of +30% for the month on the back of a strong performance for inverse VIX ETPs like XIV and ZIV. Below I’ve shown the February results of the 22 strategies we’ve blogged about previously, trading short-term VIX ETPs. Read about test assumptions or get help following these strategies.

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Stategies included in this report: First vs Second Month Futures, VIX vs Front Month Futures, VIX vs 1-Month Constant Maturity, VIX vs VXV Indices, V&M’s VIX:VXV Ratio, TM’s RSI(2)DFTB’s StDev Strategy, DFTB’s Spread Strategy, DDN’s Momentum Rotation, DDN’s VRP Strategy, 10/100-Day MA Crossovers, TWP’s Quadratic Fit, NAS’s VIX Futures Momentum, S&P 500 50/200-Day Crossovers, Brute Force Optimized VRP, LI’s Bollinger Band Strategy, LI’s SMA Crossovers, Evolution Capital Strategy, TTO’s VRP Strategy, MS’s Mean-Reversion, Macro Investor Strategy, QT’s VXV:VXMT Strategy

XIV and VXX are of course not the only show in town. Below I’ve rerun the same tests, this time applying each strategy to the less popular (or is it “underutilized”?) mid-term VIX ETPs ZIV and VXZ (click to zoom).

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Note that when any of these strategies signal new trades, we include an alert on the daily report sent to subscribers. This is completely unrelated to our own strategy; it just serves to add a little color to our daily report and allows subscribers to see what other quantitative strategies are saying about the market.

Good Trading,
Volatility Made Simple

VIX Trading Strategies in January

We’ve tested 22 simple strategies for trading VIX ETPs on this blog (separate and unrelated to our own strategy). And while I can’t speak for all traders, based on all of my readings both academic and in the blogosphere, the strategies we’ve tested are broadly representative of how the vast majority of traders are timing these products.

All but but a handful of these strategies fell in January following losses in inverse VIX ETPs like XIV and ZIV. Below I’ve shown the January results of the 22 strategies we’ve blogged about previously, trading short-term VIX ETPs. Click for for 2014 results, read about test assumptions, or get help following these strategies.

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Stategies included in this report: First vs Second Month Futures, VIX vs Front Month Futures, VIX vs 1-Month Constant Maturity, VIX vs VXV Indices, V&M’s VIX:VXV Ratio, TM’s RSI(2)DFTB’s StDev Strategy, DFTB’s Spread Strategy, DDN’s Momentum Rotation, DDN’s VRP Strategy, 10/100-Day MA Crossovers, TWP’s Quadratic Fit, NAS’s VIX Futures Momentum, S&P 500 50/200-Day Crossovers, Brute Force Optimized VRP, LI’s Bollinger Band Strategy, LI’s SMA Crossovers, Evolution Capital Strategy, TTO’s VRP Strategy, MS’s Mean-Reversion, Macro Investor Strategy, QT’s VXV:VXMT Strategy

DDN’s Momentum Rotation was the top performer of the month after a tough 2014.

The real standout in terms of consistency though continues to be the Revised TM RSI(2) strategy, a short-term mean-reversion model that has been able to capitalize on the series of brief VIX spikes that have plagued the VIX complex as of late.

XIV and VXX are of course not the only show in town. Below I’ve rerun the same tests, this time applying each strategy to the less popular (or is it “underutilized”?) mid-term VIX ETPs ZIV and VXZ (click to zoom).

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Note that when any of these strategies signal new trades, we include an alert on the daily report sent to subscribers. This is completely unrelated to our own strategy; it just serves to add a little color to our daily report and allows subscribers to see what other quantitative strategies are saying about the market.

Good Trading,
Volatility Made Simple

QuantStrat TradeR’s VXV:VXMT Strategy

This is a test of a strategy from Ilya Kipnis of QuantStrat TradeR for trading VIX ETPs like XIV and VXX. Ilya provides a framework for testing the robustness of a given set of trading parameters. I encourage you to read Ilya’s piece, but that isn’t the subject of this post. Here I test the strategy that resulted from Ilya’s analysis (with a twist).

Strategy results from 08/2008 trading XIV (inverse VIX) and VXX (long VIX) follow in blue, versus buying and holding XIV in grey. Read about test assumptions, or get help following this strategy.

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Ilya’s post found 3 different parameter values that looked promising. Here I’ve combined them into one single strategy. Strategy rules follow (read about test assumptions):

  • After the close, calculate the ratio: VXV (3-month VIX) divided by VXMT (mid-term VIX).
  • Calculate the 60-day, 125-day, and 150-day average of that ratio. These are for the three separate strategies that we will combine into one.
  • For each strategy, when both the current VXV/VXMT ratio is below the average and the average is below 1, that strategy is short vol (XIV). When both the ratio is above the average and the average is above 1, that strategy is long vol (VXX).
  • Average the signal from all three strategies. For example, 2 short vol and 1 cash signal would average out to a 2/3 position short vol.
  • Execute that signal at the following day’s close using a market-on-close order. In other words, this strategy has a 1-day lag. We’ve touched briefly on 1-day lags previously. Hold until a change in position.

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Because VXMT data is only available from 2008, we can’t test this strategy back to mid-2004 as readers are accustomed to. The strategy looks promising though despite the limited data, at the very least because some thought went into parameter selection.

Note from the equity curve above (and drawdown curve below) that the strength of the strategy has been in managing losses, and the strategy has tended to lag buy & hold when XIV has been particularly strong.

The strategy spends about 65% of all days with some position on. I should note that of those days, the vast majority (92%) are short the VIX, meaning an important mechanism for the success of this strategy is moving to cash when the ratio is above or below the average (as opposed to switching between long and short VIX).

I look forward to seeing how this strategy performs out-of-sample. Like most of the strategies we test on our blog, we’ll continue tracking this one for the benefit of subscribers.

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When the strategies that we cover on our blog (including this one) signal new trades, we include an alert on the daily report sent to subscribers. This is completely unrelated to our own strategy’s signal; it just serves to add a little color to the daily report and allows subscribers to see what other quantitative strategies are saying about the market.

Click to see Volatility Made Simple’s own elegant solution to the VIX ETP puzzle.

Good Trading,
Volatility Made Simple