Over the last two years I have become a student of trading volatility strategies. See my last Instablog article for a useful index of articles that deal with volatility trading strategies.
Volatility ETPs like (VXX) and (XIV) are great products for momentum swing trading because:
- They tend to move in waves. These ETPs follow the volatility futures and those futures move based on waves of investor sentiment of fear and complacency.
- When the ETPs get going in one direction, they continue with a lot of momentum in that direction for many days.
- They make huge moves. As long as you are betting in the right direction most of the time, you can really make nice gains.
- Because of the term structure of the futures, these ETPs tend to have a strong bias in one direction (VXX down, XIV up)
I have developed an aggressive strategy that can be used by any trader who has a full time day job and no time to watch their trades while the market is open. This is also a good strategy for any type of trading account including IRAs and avoids the pattern daytrading rules.
WARNING: Do not use any XIV strategy unless you completely understand the following statements about XIV. XIV tracks the inverse daily percentage move of the Volatility Futures short term index and is rebalanced daily. XIV has a strong upward bias when the volatility futures term structure is in Contango. XIV can lose 50%-80% of its value in hours or a few days when there is some sort of market shocking event.
The Strategy
Average True Range (ATR) is a measure of how much a stock or index moves every day. Traders often use ATR to determine where to place trailing stop loss orders. This is also known as a Chandelier Stop. A good description of using chandelier stops is here or here. Using a XIV stop loss is key to limit major losses when there is a major market shock or black swan event.
Strategy Rules:
1. Play XIV on the long side only.
2. Buy XIV if it rises two times the 14-day Average True Range above the recent closing low. Buy at the Open of the next trading day after seeing this signal.
3. Set a Stop Loss sell order at 2.5 times the 14 day ATR.
4. Every day, reset the Stop Loss order at 2.5 times the 14 day ATR. Only move the stop up. If XIV had a down day, leave the stop at the same level as the previous day.
If you have a day job like me, you can set your buy order with your broker in the morning before going to work and you don't have to watch it all day.
I pull data down from Yahoo Finance into an Excel spreadsheet every evening to recalculate the ATR and to determine where to reset the stop loss sell orders.
Chart
The Chart below shows the XIV price since the ETN's inception as well as the placement of the 2.5 ATR stop loss orders.
Note how the strategy tends to go long right at the start of new long term uptrends.
Once a new uptrend starts, it can go for several days before ending.
Because of the rising Sell Stops, we get to keep the majority of the swing gains.
If XIV is moving sideways or down, the Sell Stops move sideways.
XIV occasionally jumps quickly and the strategy often has us long at these times.
The strategy had us in cash near the start of the large drop at the beginning of August 2011.
There are significant whipsaws when we go long too early, during a downtrend, but these are offset by the times when we were correct and got long at the beginning of an extended uptrend.
Strategy Performance
The chart below overlays an equity curve on top of the same chart.
A portfolio of $10,000 would have become $38,832 since December 2012. That's 388% gains in just under 26 months - an average of 15% per month.
Notice how some times buying and holding XIV would have performed better than the strategy going to cash during a correction. This is the price we pay for having our Stop Loss orders to protect us from disaster.
The two worst drawdowns were August-November 2011 where the portfolio lost 50% and March to June 2012 where the portfolio lost 38%. In both cases, the portfolio recovered quickly.
Trading XIV is not for the faint of heart!
These results are not statistically significant because of the short time period in play and the small number of trading signals. I can't promise XIV will continue to work this well in the next two years. It is possible to get an extended string of drawdowns if we have shorter waves of fear and complacency in the VIX futures market.
You could build a similar strategy using short VXX. Since XIV is an inverse fund and it rebalances daily, it loses value due to tracking error when the underlying futures index has choppy up/down action. A VXX Short performs better than XIV most of the time. I choose to use XIV because I don't want to ever be in an unlimited risk position where my broker will be calling to liquidate my short position..
This strategy only looks at the trend and price action in XIV. There are many other volatility strategies that use the amount of Futures Contango, the S&P 500 trend, or VIX index level for entries and exits. You can improve on this strategy if you layer in additional information before buying.
I do not follow this strategy mechanically myself. I use a measure of contango and other indicators in addition to XIV price action to determine my entries and exits. I do, however, always make sure to have a sell stop in place when I am long XIV.
Disclosure: I am long XIV. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.