Friday, May 20, 2022

How To Implement VIX Strategy To Generate Profits

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Background

The logic behind our research is actually pretty straightforward when you think about it. It’s a spin on the traditional buy low, sell high strategy and indicates that investors should be buying equities (or, conceivably, other risk assets) when volatility levels are excessively high and sell when volatility is excessively low.

Why? Spikes in the are almost always associated with sharp and severe downturns in the markets. This can best be explained in the paper’s conclusion.

“While momentum is often touted as the ideal anomaly to take advantage of using sectors to express an active bet on continued performance, we find that an approach which waits for momentum to crash with a VIX spike allows for an ideal set-up to buy low and sell high when investor overreactions take place.”

As the VIX rises, stock prices tend to fall and investors, in general, tend to overreact. These types of scenarios create opportunities for smart market watchers to exploit and generate alpha.

The last three major VIX spikes all created buying opportunities that preceded sharp rebounds in equity prices.

VIX Daily Chart

The spikes highlighted are the most obvious examples, but you can see a similar relationship between smaller scale VIX spikes and stock prices at many points over the past five years. This was our general thesis. By adding risk to your portfolio when volatility levels were high, investors would essentially be buying stocks “on sale”. Positioning your bets in the right sectors also amplified the opportunity to achieve superior results.

High Level Results

We generated our backtest looking at the rolling 14-day VIX on any given trading day (in order to smooth out some of the short-term noise) and measuring the forward-looking performance over several time periods.

The results are pretty compelling.

In summary, investing in almost any sector when VIX levels are at their lowest yielded the poorest forward-looking returns. Conversely, investing when volatility levels are at their highest produced the best longer-term results.

Some of the other findings make intuitive sense as well. Cyclicals and growth areas of the market performed best coming out of a VIX spike. In theory, these sectors will likely have underperformed during a high volatility and subsequently outperformed on the rebound. The traditionally defensive sectors – consumer staples, healthcare and utilities – delivered the worst returns for the opposite reason.

At the low VIX levels, however, utilities and consumer staples were outperformers. Presumably, this would be because a period of extreme calm precedes a volatility spike, in which defensive issues likely fall less than the market.

Historically, tech outperforms in all scenarios because, well, it’s the tech sector!

In the paper, we offered a number of different scenarios in which investors could implement the VIX strategy. Similar to what I do with the existing signals, we proposed various weighting of cyclical and defensive sectors based on pre-specified VIX levels.

The one I’ll focus on here is what we called the “All-In Sector Rotation” strategy. In a nutshell, it allocates 100% to a cyclical index in high VIX environments and rotates to a 100% defensive index in low VIX environments.

As part of the research, we determined the following VIX levels to be our trigger points.

Entry & Exit Levels

Entry & Exit Levels

We ran a few different scenarios within this strategy, so you’ll see terms like equal-weighted and sector-weighted (which are just what they sound like) and static vs. rolling (which use different measuring periods to determine VIX level). The results in each of these scenarios is substantially similar, so I’ll just focus on the results of the strategy at a high level.





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