Chasing the Volatility Risk Premium

This is a test of another strategy from the paper Easy Volatility Investing from Double-Digit Numerics. The strategy trades VIX ETPs like XIV and VXX by attempting to capture the Volatility Risk Premium (VRP).

To see more from this paper, see our test of a Momentum Rotation Model.

Strategy results trading XIV (inverse volatility) and VXX (long volatility) are in blue, compared to buying and holding XIV in grey, from mid-2004 to present:

20140411.Equity-Curve

Strategy rules:

  • At the close, calculate the following: the 5-day average of the [VIX index – (10-day historical volatility of SPY * 100)]. Note that historical volatility is based on the natural log of each day’s % change.
  • Go long XIV at the close when the result of the above formula is greater than 0, otherwise go long VXX. Hold until a change in position.
  • Read about test assumptions. Get help following this strategy.

Very similar strategies have been shared in other papers, but this is the one I happen to be digesting at the moment, so I’ve tested these specific rules.

Note the decline in performance over the last year and a half. We’ve shown a similar recent decline in some other strategies we’ve tested here on the blog, but the decline in the VRP strategy seems particularly pronounced given what an effective trade it has been in the past. In a future post we’ll dig deeper into this subject.

20140411.Stats

The strategy is attempting to estimate and profit from the volatility risk premium (VRP). What is the VRP? From the paper’s author:

The premium that we seek to exploit is the Volatility Risk Premium (VRP) which is the premium that an investor in some asset pays to reduce exposure to the volatility of the future returns of that asset. In other words, the price hedgers are prepared to pay to speculators to offload price risk. In our case the asset is the S&P500 index.

The VRP is reflected in S&P500 options by options being overpriced. Sellers of these options (who are essentially “selling volatility”) receive the VRP through these higher prices. Now the VIX is a measure of the “implied” volatility of these options therefore the VIX is too high compared to where it should be if it were an unbiased predictor of future S&P500 volatility.

In a nutshell the VIX overpredicts the S&P500 volatility and this overprediction represents the VRP.

I’ve chased the VRP using my own unique (but conceptually similar) approach for a couple of years now, and it’s one of many components of our strategy, so I’ve been concerned for a while now that this particular trade has begun to break down. Needless to say, it’s something I continue to monitor closely.

20140411.Drawdown-Curve

20140411.Periodic-Returns

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

Posted in Strategy Backtests.