- High total returns
A modest portion of my overall portfolio will be dedicated to this strategy. Volatility and risk are crazy high. Potential returns are also crazy high. We’re talking annualized returns approaching 100% over long periods. That comes at a price. It’s possible for this strategy to lose a ton in a short amount of time.
I spent a lot of time researching the new volatility ETNs on the market. I was mainly focused on two – VXX and XIV. Do a google search if you want to learn more about them. There’s a lot to learn so make sure you take the time to do so. (Note: I’m greatly indebted to Juan of the Inteligent Investor Blog. He posted a super helpful spreadsheet of simulated VXX values in this post: http://investing.kuchita.com/2011/08/21/vxx-data-since-vix-futures-avilable-march-2003/ The charts of XIV and related strategies below are based off of values in his spreadsheet.)
From what I read it seemed like XIV could be a big winner over time due to the contango that often occurs in the first two VIX futures. The problem is it’s subject to huge drawdowns during bear markets and large volatility spikes. I tried many different strategies to time XIV/VXX entries and exits and in the end found a couple variables that appear to be super helpful in timing these plays.
One valuable key to a timing strategy appears to be the volatility of volatility. More specifically, I’m referring to the standard deviation of the VIX index during the recent past. The chart below compares simulated XIV values to the standard deviation of daily percent changes in the VIX index over the previous 10 trading days. You’ll notice the standard deviation spiking right as XIV prepares for major plunges.
Using the following rules would have theoretically made one a lot of money in the past:
Rule 1: Go long VXX when the standard deviation rises above 11 percent.
Rule 2: After Rule 1 has gone into effect, go long XIV when the standard deviation falls below 10 percent.
Here is a look at the results of such a timing model:
Another valuable piece of information is the relationship of the first and second month futures over the recent past. The average level of contango tends to be high when XIV is rising. The opposite has been true when the futures are characterized by strong backwardation. The chart below compares XIV to the average front month premium over the previous 20 days. Negative values represent contango and positive values represent backwardation.
Using the following rules would have also theoretically made one a lot of money in the past:
Rule 1: Go long VXX when the average front month premium over the past 20 days is above 5%.
Rule 2: Hold cash when the average front month premium over the past 20 days is between -5% and 5%.
Rule 3: Go long XIV when the average front month premium over the past 20 days is below -5%.
Here is a look at the results of this timing model:
Both models provide great returns with much less drawdown than simulated XIV values. That said, both did have significant drawdowns during the testing period. The problem with the VIX standard deviation model is that sometimes XIV will gradually drift lower when the standard deviation is low. This was the case in parts of 2007. Long periods of backwardation combined with a low VIX standard deviation are a big threat that need to be addressed. The problem with the futures spread model is that it wont react fast enough when VIX is spiking fast and hard. This was the case in 2010.
A hybrid approach addresses the weaknesses of each individual model. It will keep one out of XIV during periods of backwardation/ weak contango even when the VIX isn’t super volatile. It will also get one out of XIV faster when the VIX is spiking crazy fast.
The Alpha strategy uses the following rules:
Rule 1: Go long VXX when the standard deviation of VIX over the past 10 days rises above 11 percent. Stay in VXX till the standard deviation falls below 10%.
Rule 2: Go long VXX when the average front month premium over the past 20 days is above 5%.
Rule 3: Hold cash if the average front month premium over the previous 20 days is between -5% and 5% AND Rule 1 is not in play.
Rule 4: Go long XIV when the average front month premium over the previous 20 days is below -5% AND Rule 1 is not in play.
Below are the results of the Alpha strategy compared to the other two models:
Stats related to all three model backtests can be seen below. Max drawdown for the Alpha model was significantly less than the other two. Returns weren’t quite as good as the StDev model but the Alpha model should be much more robust for varying market conditions in the future.
One final rule needs to be added to help protect against monster one day jumps in the VIX index (think VIX spikes greater than 50-100% or more in a day). A stop should be utilized when in a XIV position. Ideally, I’d like to have a 10% stop for each day that I’m in XIV but I don’t want to set that up each day and don’t know how to do it automatically. So…I plan to use a 15% trailing stop that i will readjust if the price gets close to the stop value. This still doesn’t offer 100% protection. A monster gap down could still theoretically decimate XIV. Let’s hope that doesn’t happen!