Trading Strategy: VIX Spread and the Stock Market

This post will be more complicated than most I write, but I think folks interested in the VIX and volatility and what they tell us about the markets will find this to be a new (and I hope useful) concept. If you’re unfamiliar with the VIX, read VIX & More’s primer.

As I discussed in The VIX isn’t Magical, the VIX is usually pretty predictable. Even though the VIX is meant to be forward-looking, it just tends to reflect recent past market volatility. To illustrate, the graph below shows the VIX (red) relative to the rolling 20-day volatility of the S&P 500 (blue) YTD.

It is important to note, that generally speaking, the two (one looking backwards, the other supposedly forward) follow each other closely. Occasionally however, the two diverge. This was seen in late-Oct. /early-Nov. when the VIX fell sharply without a similar change in historical volatility (red arrow).

Bill Luby of VIX & More has been looking at how the stock market responds when divergences such as these occur. The strategy I’m about to share is a contribution to that discussion. On the surface, my conclusions contradict Bill’s but that’s because we’re looking at different timeframes (I’ll discuss further at the end of this post).

TRADING STRATEGY

First, let’s look at the graph above in a different way. The graph below shows the difference between the VIX and 20-day historical vol. in percentage terms in blue. Bill refers to this as the “VIX Spread.” In red is a 50-day moving average of this spread.

Note that generally the VIX runs hotter than historical volatility (i.e. the blue line is greater than zero), but occasionally (such as now), it dips below historical volatility.

Next, let’s look at the results of trading strategies that go long the S&P 500 tomorrow when the VIX Spread today is below (red) or above (green) the 50-day moving average. Geek note: this test is frictionless.

[logarithmically-scaled]

The graph shows that historically the market has been stronger when the spread between the VIX and historical volatility has been lower, or put another way, when the VIX foresees less future volatility than it usually does relative to past volatility.

This approach stood up very well against the bear market of the early 2000s and reduced volatility and average drawdowns in our hypothetical portfolio by about 30% and 70% respectively over the entire test, while still matching market returns.

Note however, that the test above only extended to May of 2007. This relationship fell apart (reversed actually) in the bear market that began late in 2007. The graph below shows the same strategy traded to the present.

[logarithmically-scaled]

The question then becomes - Has this VIX Spread trading strategy temporarily or permanently changed course?

It’s hard to say. Most of the losses came in October of this year, and as I’ve discussed before, most contrarian indicators completely fell apart in October. Savvy readers will note that this strategy is also contrarian in a roundabout way. High volatility tends to accompany down markets (which Bill touched on here), so buying when the VIX is “relatively” low as compared to past volatility could be interpreted as trading against downward pressure.

Note that these results appear to contradict Bill’s conclusions about the VIX Spread (namely, that high spreads are bullish), but I think that’s because Bill’s results are looking at returns further out (over the following couple of weeks) versus the next day.  I’m going to continue poking and prodding at this strategy to include Bill’s more long-term oriented observations as well.

Stay tuned, there’s more to follow.

Comments

[JasonC:]

Excellent post, real substance by the standards of Seeking Alpha. Thanks for sharing it.

2008 Nov 12 04:02 PM

[Raymond Mic...:]

If you were to adjust your position sizes based on prevailing short-term market volatility, while you still would have had the drawdown in October, 2008, it would have been a fraction of the market's drawdown. Given the mean-reversion in the S&P 500, which has only gotten stronger in recent years, it's likely that the relationship you point out will continue to be strategically advantageous--as long as you control your risk based on the prevailing volatility in the market to backstop yourself for the times when the index waits a day (or two or three) to revert.

2008 Nov 12 06:10 PM

[zinfool:]

Great piece of analysis. The Hedge Fund Redemption and margin calls that started in October, and continues through current, and probably will end about Dec.1, plus the Mutual Fund Window Dressing for end of the year "look", are probably responsible for the extreme divergence we are seeing in the chart, that reversal Michael talked about.

Nice to see charts broken into components that I can not easily do, get to see trends and acceleration actually plotted. Thank you!

I am actually short the VIX now (in put options) We will see if the divergence in the VIX can out last the time frame of the puts! History says no, Buffet would say yes! I think Buffet's view may get me!! Dec. 17th is expiration.

2008 Nov 13 09:52 AM

[Urbane Gori...:]

Thanks for the article.. I spend a lot of time comparing the VIX or dollar with the SPY or ultra ETFs, looking for correlations. Your mention of the divergence from typical activity is very telling. In fact, I suspect that this market **is** different. The divergences between the dollar and gold, the fact that oil moves with the market are all issues that confound investors and may well have caused a lot of the losses within funds.

Thx jegan

2008 Nov 13 04:39 PM

[granger:]

Thank you, good stuff

2008 Nov 14 02:15 AM

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Jul 10 02:37 AM