Using Stock Market Trend-Following to Time VIX ETPs

This is a test of a strategy a number of readers have requested: trading VIX ETPs (ex. XIV and VXX) by trend-following the broader stock market (ex. the S&P 500). For simplicity’s sake, I’ll be looking at the most common of trend-following strategies: 50/200-day simple moving average crossovers.

But first, a look at how 50/200-day crossovers have performed at their stated purpose: timing the stock market, since 1931.

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Strategy rules in blue: go long the S&P 500 at the close when the 50-day simple moving average of the S&P 500 (cash index) will close above the 200-day moving average, otherwise to cash. Hold until a change in position.

For comparison, the inverse rules (long when 50-day < 200-day) are also included in orange.

Wonk notes: the moving averages have been calculated based on the cash index, but trades are executed on dividend-adjusted data, to match how traders would actually execute the strategy. This is a proof of concept, so I’ve ignored return on cash and transaction costs/slippage.

Note how the market still has a tendency to go up following a cross under (orange line). The strength of the crossover strategy (blue line) is in managing drawdowns/losses, not improving returns. To illustrate, a drawdown curve of both variations:

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Note the number of significant drawdowns the crossover strategy would have avoided.

A natural follow on question is whether this drawdown-avoidance would be useful in trading VIX ETPs, which are highly correlated with equities, but are prone to far more severe drawdowns.

The graph below looks at that question. Here I’ve applied the same crossover strategy calculated based on the S&P 500, but I’ve executed trades on XIV (inverse VIX). Again, the indicator is calculated based on the stock market, but trades are executed on XIV.

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Note that in this test I have applied transaction costs/slippage. Read about test assumptions.

The next graph, a drawdown curve, is even more important as it shows how well the strategy has managed losses:

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The short answer is that, over the limited history we have available to us, the strategy has done a poor job managing losses in XIV (and for what it’s worth, ZIV as well). In every significant drawdown since mid-2004, the strategy would have eaten a hefty portion of the loss before moving to cash.

Bear in mind that this was during a period when the strategy did a good job at it’s stated purpose, managing losses when trading the stock market, meaning that these subpar results are probably the norm and not the exception.

I see similar results using a 10-month moving average (akin to Meb Faber’s excellent asset class-level strategy).

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I’m not saying the idea has no merit.

I found better results when using shorter moving averages, which might be due to the more volatile nature of these products and the need to move out of them more quickly when the market breaks down (or it might just be a product of curve-fitting).

But in any case, I’m not sure why anyone would take this approach as opposed to some of the simple strategies we’ve tested on this blog that are directly measuring things that are directly related to VIX ETPs (like the state of the VIX futures term-structure or the volatility risk premium).

If one were dead set on using a moving average crossover strategy, I think a more common-sense solution might be applying the moving averages to XIV (or ZIV) itself, as we did here.

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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

Posted in Strategy Backtests.