Daily Commentary - Posted on Friday, December 19, 2014, 7:21 PM GMT +1
Trading (Mid-Term) Volatility – Periods Of Low Historical Volatility
A couple of weeks ago I started a series of postings, all dealing with trading volatility ETNs / ETFs like XIV® (VelocityShares Daily Inverse VIX Short-Term ETN) and VXX (iPath® S&P 500 VIX Short-Term Futures™ ETN) and respective trading strategies. One of those strategies was DDN’s VRP Strategy (Double-Digit Numerics , Volatility Risk Premium) due to its exceptional performance – at least until December 2012 – and its compelling approach (from the paper Easy Volatility Investing from Double-Digit Numerics).
This posting is about trading the ZIV® (VelocityShares Daily Inverse VIX Medium-Term ETN) – linked to the inverse of the daily performance of the S&P 500 VIX Mid Term Futures™ Index ER, and VZZ® (iPath Long Enhanced S&P 500 VIX Mid-Term Futures ETN) – linked to a leveraged return on the performance of the S&P 500 VIX Mid-Term Futures™ Index TR – , offering exposure to a daily rolling short|long position in the 4th, 5th, 6th and 7th month VIX® futures contracts.
At the same time, I’d like to address a problem which specifically applies to the Volatility Risk Premium Strategy (but probably not limited to): Periods of relatively low historical volatility, while implied volatility ( VIX® and the respective front and second month futures (Ticker: VX1|VX2) ) either spikes up or at least (steadily) rises to a (significantly) higher level (investor fear). Due to the fact that during those periods implied volatility continuously (significantly) exceeds historical (realized) volatility, the strategy keeps holding onto a losing position ( XIV® or ZIV® ) instead of buying into the momentum ( VXX® or VZZ® ).
But first of all the customized Volatility Risk Premium (VRP) Strategy rules (always market on close):
- Long ZIV: x-day moving average of [VX1|VX2 (30-day const. maturity) – 2-day historical volatility of S&P 500 * 100] ≥ 1
- Long VXZ: x-day moving average of [VX1|VX2 (30-day const. maturity) – 2-day historical volatility of S&P 500 * 100] < 1
- Hold until a change in position.
Please note: Ticker: VX1|VX2 represent the VIX® front and second month futures, merged into a continual time series as a 30-day constant-maturity futures price (the basis for VXX® and XIV®).
Image I shows the respective equity curves: the VRP (customized) Strategy (black line), and – for exemplary purposes (with hindsight!) – in order to demonstrate the problem mentioned above and a possible solution at the same time – a tuned copy of the VRP (customized) Strategy (blue line), where during periods of relatively low historical but rising (rocketing) implied volatility (highlighted by yellow boxes) historical volatility has been leveraged by a factor of 10 (finally in order to trigger a buy VXZ® more often).
The respective periods are (in excerpts, for exemplary purposes):
Image I – Total Equity Curve(s)
(03/25/2004 – present)
It is clearly recognisable that while the basis strategy (not leveraged) shows a poor performance during those periods of low historical / rocketing implied volatility (due to holding onto a losing position in ZIV® way too long until finally historical volatility keeps pace up with implied volatility, especially during time frame 2), the tuned (leveraged) strategy switches from short to long volatility at the proper time.
Image II shows time, duration and severity of respective drawdowns (including the tuned (leveraged) strategy’s advantage/disadvantage compared to the basis strategy (yellow areas).
Image II – Drawdown Curve(s)
(03/25/2004 – present)
Image III shows the respective statistics. Please keep in mind that the tuned (leveraged) strategy is trading with hindsight in order to demonstrate the problem described above which specifically applies to the Volatility Risk Premium Strategy (but probably not limited to).
Image III – Summary Statistics
(03/25/2004 – 10/15/2014)
Possible solutions to fix the problem concerning (relatively) low historical volatility / rising (rocketing) implied volatility when / as long as apropriate (this time without hindsight):
- leveraging the respective historical volatility,
- increasing the cut-off (increasing the ‘1’) – triggering “long volatility” more frequently,
- shortening the x-day moving average (in order to get the system to react more quickly),
to be continued … (means more on this to come, stay tuned)
Have a profitable week,
Disclosure: I’am long/short XIV, and long/short VIX, RVX and EURO STOXX 50 volatility futures.
Remarks: Due to their conceptual scope – and if not explicitly stated otherwise – , all models/setups/strategies do not account for slippage, fees and transaction costs, do not account for return on cash and/or interest on margin, do not use position sizing (e.g. Kelly, optimal f) – they’re always ‘all in‘ – , do not use leverage (e.g. leveraged ETFs), do not utilize any kind of abnormal market filter (e.g. during market phases with extremely elevated volatility), do not use intraday buy/sell stops (end-of-day prices only), and models/setups/strategies are not ‘adaptive‘ (do not adjust to the ongoing changes in market conditions like bull and bear markets). Index data (e.g. S&P 500 cash index) does not account for dividend and cash payments.
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