Trading Strategy: The VIX Spread and the Stock Market
By Michael Stokes | November 12, 2008 | 10:30 AM | 0 Comments
This post will be more complicated than most I write, but I think folks interested in the VIX and volatility and what they tell us about the markets will find this to be a new (and I hope useful) concept. Unfamiliar with the VIX? Read VIX & More's primer.
As I discussed in The VIX isn't Magical, the VIX is usually pretty predictable. Even though the VIX is meant to be forward-looking, it tends to just reflect recent past market volatility. To illustrate, the graph below shows the VIX (red) relative to the rolling 20-day volatility of the S&P 500 (blue) YTD.
Note how generally speaking the two (one looking backwards, the other supposedly forward) follow each other closely. Occasionally however, the two diverge. This was seen in late-Oct./early-Nov. when the VIX fell sharply without a similar change in historical volatility (red arrow).
Bill Luby of VIX & More has been looking at how the stock market responds when divergences such as these occur. The strategy I'm about to share is a contribution to that discussion. On the surface, my conclusions contradict Bill's but that's because we're looking at different timeframes (I'll discuss further at the end of this post).
TRADING STRATEGY
First, let's look at the graph above in a different way. The graph below shows the difference between the VIX and 20-day historical vol. in percentage terms in blue. Bill refers to this as the "VIX Spread". In red is a 50-day moving average of this spread.
Note that generally the VIX runs hotter than historical volatility (i.e. the blue line is greater than zero), but occasionally (such as now), it dips below historical vol.
Next, let's look at the results of trading strategies that go long the S&P 500 tomorrow when the VIX Spread today is below (red) or above (green) the 50-day moving average. Geek note: this test is frictionless.
[logarithmically-scaled]
The graph shows that historically the market has been stronger when the spread between the VIX and historical volatility has been lower, or put another way, when the VIX foresees less future volatility than it usually does relative to past volatility.
This approach stood up very well against the bear market of the early-2000's and reduced volatility and average drawdowns in our hypothetical portfolio by about 30% and 70% respectively over the entire test, while still matching market returns.
Note however that the test above only extended to May of 2007. This relationship fell apart (reversed actually) in the bear market that began late in 2007. The graph below shows the same strategy traded to the present.
[logarithmically-scaled]
The question becomes: has this VIX Spread trading strategy temporarily or permanently changed course?
It's hard to say. Most of the losses came in October of this year and as I've discussed before, most contrarian indicators completely fell apart in October. Savvy readers will note that this strategy is also contrarian in a roundabout way. High volatility tends to accompany down markets (which Bill touched on here) so buying when the VIX is "relatively" low compared to past volatility could be interpreted as trading against downward pressure.
Note that these results appear to contradict Bill's conclusions about the VIX Spread (namely, that high spreads are bullish), but I think that's because Bill's results are looking at returns further out (over the following couple of weeks) vs the next day. I'm going to continue poking and prodding at this strategy to include Bill's more long-term oriented observations as well.
More to follow.
Happy Trading,
ms
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