(This article was originally published on Trading Volatility on 1/22/2015.)
In early December we made a second strategy for trading VXX and XIV available to our subscribers: the Volatility Risk Premium (VRP) strategy. You may remember me outlining the excellent performance of this strategy in my previous blog post, Volatility Strategies - Separating Fact From Fiction. I liked the strategy so much I decided to make a few adjustments and launch our own version of VRP to use along with our VXX Bias on our Daily Forecast page.
Why use two strategies for trading volatility ETPs? Because no single strategy is perfect and the market is inherently unpredictable. Using two complementary strategies simultaneously compensates for inherent weaknesses within each of the strategies, reduces drawdowns, and smooths out returns over months and years.
The VXX Bias and VRP strategies each take a very different approach for maximizing gains. The VXX Bias strategy is based on the term structure and momentum of VIX futures, while VRP is based on the price of VIX and historical volatility measurements. However, each of these strategies thrive and struggle depending on the specific market conditions. For example, the VXX Bias strategy has an advantage in handling periods of moderate drawdowns and sustained periods of backwardation. Meanwhile, the VRP strategy tends to be better with choppy markets and periods of gradually increasing volatility when VIX futures are in contango.
You can see in the backtest results below that neither strategy consistently outperforms the other over a given year, although both VXX Bias and VRP are vastly superior to a buy-and-hold approach with XIV.
As you can see in the chart above, using the VRP and VXX Bias strategies together (the green columns) provide more consistent returns than using just one strategy alone. In most years the "VRP + VXX Bias" strategy return falls roughly halfway between the VXX Bias and VRP strategies used on their own. (Note: There are a couple ways to incorporate two strategies, but the easiest way is to trade in VXX or XIV only when they agree on the trade direction, which is how the above results are generated.)
Looking at the strategy statistics below, we see that the VRP + VXX Bias strategy benefits from a reduced maximum drawdown and a 1.14 Sharpe Ratio.
Some other relevant stats for trading only when VRP and VXX Bias agree on direction (years 2004-2014):
- # of trades: 128
- Avg hold time: 10.76 days
- # of days out of market in cash: 678 (out of 2711) --> 25%
- Avg gain: 5.69%
- Max gain: 216.2%
- Max loss: -20.6%
The equity curve for each of the strategies (below) illustrates the smaller drawdowns and improved performance of using VRP and VXX Bias together:
Table of annual returns for the above data:
Full test data for both the VRP and VXX Bias strategies can be found in the spreadsheets at the bottom of the Subscribe page. You can also read more about our trading strategy on our Strategy page.
Access to our daily indicators and automated alerts for both the VRP and VXX Bias strategies is available via subscription to Trading Volatility+.
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Hypothetical and Simulated Performance Disclaimer
The results are based on simulated or hypothetical performance results that have certain inherent limitations. Unlike the results shown in an actual performance record, these results do not represent actual trading. Also, because these trades have not actually been executed, these results may have under- or over-compensated for the impact, if any, of certain market factors, such as lack of liquidity. Simulated or hypothetical trading programs in general are also subject to the fact that they are designed with the benefit of hindsight. No representation is being made that any account will or is likely to achieve profits or losses similar to these being shown.