XIV and the Whipsaw Regime
As I gain experience I realize more and more how fluid the markets can be. Always evolving and changing. Keeping short term traders on their toes. Finding strategies and relationships that endure for a significant amount of time is quite difficult. You don’t appreciate that at the beginning of the journey.
I’ve been fascinated by the VIX futures market for a few years now, trading the futures through various ETPs. Quite a number of trading strategies have appeared on the internet over the past couple years as these products gained popularity.
One thing I started noticing last year, and to a degree back in 2012 was that XIV (the popular short volatility product) was experiencing a change in character. The first thing I noticed was that high realized volatility of the VIX was no longer reliably leading to significant declines in XIV. What used to be a good signal to go long volatility started acting more as a good entry point to short volatility.
I later noticed that mean reversion type strategies began outperforming those of a follow through flavor. I’ve documented this on the site in the case of daily and monthly mean reversion strategies doing relatively well. Just looking at a long term chart of XIV shows it has been far less “trendy” and far more choppy lately. I think this is ultimately the reason why many popular strategies (many of which benefit when XIV/VXX have long trends) have performed poorly of late. It has been whipsaw city for many trying to trade volatility using traditional methods. The topic of many popular strategies struggling was brought up recently on the Volatility Made Simple site in this post. Check out that site if you haven’t already.
I am calling this choppy period the Whipsaw Regime. It too will pass and the VIX futures will behave differently yet again. Until that happens, I find it interesting to look at what’s done well the past couple years. Below are three strategies that would have thrived in this choppy period.
Strategy 1: Hold XIV when the volatility risk premium (VRP) is narrow or negative. There are many ways to calculate the VRP. I’ll use the same calculation used in the “Easy Volatility Investing” paper written by Tony Cooper. Strategy 1 will hold XIV when the VRP is below 3.
Strategy 2: Hold XIV when it closes at a three day low. Sell when it closes above a three day low.
Strategy 3: Hold XIV when VVIX (implied vol of VIX) is above 90.
The chart below shows how each strat performed since 2012. Impressive performance is mainly due to the choppiness experienced by the VIX futures.
Why would few have predicted the success of these type of mean reversion strategies at the beginning of 2012? That’s easy. Such strats would have sucked big time in most earlier periods – often coinciding with the absolute worst times to short volatility.
Below is a more complete chart with performance back to 2007. You can see that the recent performance has been very different from the past.
From a long term perspective, I believe playing mean reversion in VIX futures (at least on the short side) is a recipe for huge losses during the next big vol move or bear market. I’m definitely not advocating anyone to do so. Then again, perhaps it is this conviction by myself and others that will keep the mean reversion trade going for a while.