Trading Volatility2 Capturing the Vrm

8/10/2019 Trading Volatility2 Capturing the Vrm

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The return is considerable but since the VIX is not tradable, this particular return is not

realizable.

Volatility Instruments ETNsSo how do we trade practically trade volatility in the real world? The answer: Exchange

Traded Notes (ETNs).For those who are not familiar with ETNs, theyre simply debt instruments traded on an

exchange, in much the same manner as a stock is traded. ETNs are designed to track anunderlying index or benchmark, giving investors access to the returns of the tracked benchmark.ETNs are issued by an underwriting bank. When an investor buys an ETN, the underwritingbank promises to pay the amount reflected in the index, less investor fees. The risk thenassociated with ETNs is if the underwriting bank were to go bankrupt and the investment to lostvalue. The ETNs traded by our system are extremely popular, with very large daily volumes.

The volatility systems we are going to outline trade the following two ETNs:- VXX is the iPATH S&P 500 VIX Short-Term Futures ETN issued by Barclays.- XIVis the Daily Inverse VIX Short-Term ETN issued by Velocity Shares.Both the VXX and XIV are traded on the American Stock Exchange (AMEX)and are based

on the value of the S&P 500 VIX Short-Term Futures Index.For practical purposes, it is easier to take long positions (to buy) in an ETN than to take

short (tosell) positions. For instances where we wish to go long volatility we buy VXX, while ifwe wish to be short volatility we buy XIV, since XIV tracks the inverseVIX Short-Term Futures.

Contango IndicatorWe know from the existence of the VRP that the market tends to overestimate future

volatility compared to actual volatility. Within the futures market, this concept is known asContangoa situation where the futures price of the VIX is higher than the expected spot price.

To visually plot this phenomenon, we use our Contango indicator (shown in green infigure 2.0 and 4.0). The formula for this indicator is shown below:Contango Indicator= 10 Period Moving Average of (Close of $VXV Close of $VIX)where

$VXV = CBOE S&P500 3-month Volatility Index and VIX = CBOE Market Volatility Index.Thus in general, we buy VXX when volatility rises (stock market generally falling and the

contango indicator is below zero) and buy XIV when risk and volatility reduce i.e. typically whenthe stock market is rising and the Contango indicator is above zero.

The XIV SystemThe XIV system is a medium term trend-following trading strategy and is designed to

capture the inherent volatility risk premium. Figure 2.0 shows the chart configurations as well asthe buy and sell signals generated by the XIV system. Solid dark green lines indicate winningtrades, while solid red lines indicate losing trades. As shown on the chart, trades are enteredwhen our Contango indicator is above zero (green) and XIV experiences a fall after theParabolic Stop and Reverse trailing stop reverses above price (shown by green boxes). Trades

are closed out immediately when the stop reverses again.


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Figure 2.0 XIV daily chart showing the trades placed by the XIVsystem.

As we mentioned earlier the Vix has a mean reverting nature which we take advantage

of with this trading method. Firstly as weve just said we use the Contango indicator to set thelonger term trend. We then look for a counter trend move. For this model we simply wait forprice to be trading below the Parabolic SAR. When this occurs the exact entry method can be anumber of different things. A simple entry mechanism could be to utilise the RSI indicator with ashort term time frame, example 3 or 4 periods and wait for this to trade below 25 representing ashort term oversold market and then an entry can be taken the next day on the open. This isnice and simple and very effective, but can often be early. A stop loss of 20% can be used orsimply close for a loss if the Contango indicator turn to red without using a stop loss, meaningthe Vix futures move into a period of backwardation.For our exit we simply wait for price to begin trading above the Parabolic SAR, if price touchesthe Parabolic during the trading session we simply exit the next bar on the open.


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The trading results for the XIV system are shown in table 1.0 and the equity curve infigure 3.0. This system displays exceptional results with a win rate over 85%, a high averagetrade size of around $2000 (on a $10,000 trade size) and an extremely high profit factor. Thesystem trades on average 5-7 times per year. Bear in mind there is limited history with thisbacktest as the VIX only started trading in 2010, however with a little extra effort the samemethod can be tested on the Vix itself (switching long trades to short trades and vice versa) sothat you can backtest the method back to 2004.


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Table 1.0 Results (hypothetical) for the XIVtrading system from 2011.

We update the data for our XIV system daily and provide buy and sell signals based on thissystem, contactHalifax New Zealandor sign up tofree 60 day trialof our signal service.
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Figure 3.0 Equity curve for the XIVsystem.

The VXX System

The VXX system is designed to capture the rapid rises in volatility that occur whenmarket risk rises and the stock market falls. Figure 4.0 shows the chart configuration and thebuy and sell signals generated by the VXX system. Trades are entered into when our Contango


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indicator is below zero (red), and are closed out when the Contango indicator goes back abovezero (green). Its really that simple but has the potential to make large profits in bear markets.

The system only trades on average 1.3 times per year with a low win rate. The tradingresults for the VXX system are shown in table 3.0 and the equity curve in figure 6.0. This maynot seem too exciting but it does capture some very good trades when fear levels rise, such asin the recent market drop in 2008. The system also works well in conjunction with the XIV

system which trades more often when volatility is falling and the market is rising. For moreinformation on our VXX system, contactHalifax New Zealandor sign up tofree 60 day trialofour signal service. We should also point out that we have tested this method on the VIX futuresgoing back to 2004 as sample size on XIV and VXX starting in 2010 is far too small for arealistic backtest.

Figure 4.0 VXX Daily Chart showing the trades placed by the VXXsystem.
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Figure 5.0 Equity curve for the VXXsystem.


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Table 3.0 Results (hypothetical) for the VXXtrading system from 2009.

Given the high volatility of returns traders should really only allocate 20% or less of theirportfolio to this strategy as overnight moves of 10% or more are not uncommon.

ConclusionOverall, we have outlined two easy to implement and historically incredibly profitable

volatility trading strategies. These strategies are suited to trading accounts of all sizes as bothstrategies trade on very liquid ETNs with high average trades, making the impact of brokerageminimal. For more information on any of the strategies presented in this article, or for help withimplementing the strategy please contact any of the authors below by visitingwww.halifaxonline.co.nz

Andrew Gibbs is the director and head trader for Halifax New Zealand a full servicebrokerage offering broker assist and managed systems across Equities, Futures, Options andForex.

Trading Volatility2 Capturing the Vrm

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