Using VXO to time the SP 500
Here’s a potentially useful indicator for timing the S&P 500 on a weekly basis. Consider the following two strategies:
1. Hold SPX when VXO rose the previous week, else hold cash.
2. Hold SPX when VXO declined the previous week, else hold cash.
Here’s a chart comparing the two strategies since 1986 (not adjusted for dividends).
Not bad. Risk/reward has historically been better when VXO rose the previous week. I guess this makes sense from a mean reversion standpoint. It seems to me this indicator works best when market volatility is high (e.g. late 90′s/early 00′s and financial crisis-present). The indicator wasn’t as valuable during the early 90′s and 04-07 period.
The strategy experienced a number of big losses in this backtest. This happened when SPX fell sharply several weeks in a row while VXO continued to break out to new highs. A filter could be added to the above strategy to filter out some of the potentially big declines. One effective filter would be to avoid holding SPX when VXO closes the previous week more than 20% above its 5 week moving average. The parameters for the filter seem fairly robust. Setting the % too low will weed out a lot of profitable weeks while setting it too high will fail to avoid many of the worst losses.
The chart below compares two strategies:
1. Hold SPX when VXO rose during the previous week AND VXO closed the previous week less than 20% above its 5 week average, else hold cash.
2. Hold SPX when strategy #1 is not in play, else hold cash.
A number of large losses are filtered out without sacrificing too much performance in other time periods.
Here are some stats for the whole period and for 2009 to present.
All data is from Yahoo Finance. Using VIX would have generated similar, though not quite as good results. You can download an Excel copy of this backtest here: VXO SP500 Weekly Strategy