A Low Volatility Strategy for Trading High Volatility
We’re going to show you a volatility trading model for VXX which has correctly predicted the price of VXX 97.3% of the time since VXX started trading in 2009. The test results are up through the end of May 2012.
Trading volatility, especially VXX, has become a big game among professional traders. You only have to look at the continuously rising average volume in VXX, combined with the many new volatility products that have been coming to the market over the past year, to know that volatility is beginning to join the ranks of other asset groups such as stocks, ETFs, options, forex, and futures.
Much has been written about how to trade VXX; unfortunately the majority of the early volatility trading strategies were incorrect. Too many people were comparing VXX to VIX and had considered them the same instrument. They’re not.
VIX is an index that settles on a value each day based on the underlying vehicles in the index. VXX is the expected future value of where traders believe volatility will be in the near-term future. One is today’s value (VIX). The other is the marketplaces prediction of where these prices will be in the future (VXX).
There are certain characteristics of volatility which are inherent (and sometimes in conflict with each other). The academic world has shown decades ago that volatility is mean reverting. When volatility gets too far away from its average price over a period of time, it tends to reverse back to its average price (it reverts to its mean). Volatility is also auto-correlated. If volatility rises today, it has a higher chance of rising tomorrow.
Taking these key points into mind, what we will do is look to take the above two concepts and apply them to a simple to use strategy which has done a great job predicting the future price of VXX over a 3 ½ year period.
Here are the rules for the model:
- The 2-period RSI of VXX closes above 90. Sell short on the close the first of six possible units of VXX (1/6th of a full position). If you are unable to borrow or to short VXX, XIV is the inverse which is used to go long.
- If VXX closes higher than your entry anytime you’re in the position, short 2 additional units to get you up to 3 total units of a possible 6. You are now short ½ of a full position.
- If VXX closes higher than your second entry, short 3 additional units to get to a full short position.
- Hold the position until the 2-period RSI closes under 50.
Here are the test results:
VXX Trading Model Monthly Results
Here are the highlights of the results:
- 97.3% of the trades have been wining trades (36 of the 37 signals have been profitable).
- We’ve never seen numbers like this in equity trading.
- Within a portfolio, the annual returns have been 19.3% with a max drawdown of only 9.65%
- The Sharpe Ratio, measuring the amount of risk in conjunction with its returns is 3.00, an extraordinary number for an overnight trading method.
- Every month of testing but one has been break-even or profitable from 2009-May 2012.
The 2-period RSI of 90 is non-optimized. Other high levels show the same type of behavior. Also, the 1-2-3 scale-in is strong but so are a number of other scaling-in versions. We’ve tested dozens of other combinations and all show solid positive results.
What we have just shared with you is a simple to use strategy to trade volatility. The model’s test results have been substantial and it will be interesting to follow this in the future. There are also a number of additional ways to trade this including with options and with other volatility ETFs.