Friday, July 13, 2007

The TradingMarkets 5% VIX Rule

TradingMarkets is one of many proponents of using the 10 day simple moving average of the VIX to help time one’s exposure to the broader markets. In their own words:

The proper way to use the VIX is to look at where it is today relative to its 10 day simple moving average. The higher it is above the 10 day moving average, the greater the likelihood the market is oversold and a rally is near. On the opposite side, the lower it is below the 10 day moving average, the more the market is overbought and likely to move sideways-to-down in the near future.

This wisdom is further distilled into what TradingMarkets calls The Trading Markets 5% Rule: “Do not buy stocks (or the market) anytime the VIX is 5% below its [10 day simple] moving average.”

Today the CXO Advisory Group is out with their analysis of the 5% rule. They conclude that “the TradingMarkets 5% VIX rule is of limited practical use and does not support a standalone trading strategy that keeps up with buy-and-hold.”

But before you click on to the next story, you should note that the CXO analysis actually goes far beyond an evaluation of the 5% rule and looks at returns for the S&P 500 index for all 1% increments from 0-10% above and below the 10 day SMA. CXO’s graph of the results, which I have included below, clearly shows that the 5 day SPX return is strongly correlated with increasingly higher readings in the VIX’s 10 day SMA. This should be of no surprise to regular readers, who by now are surely used to feeding at the trough of mean reversion.

The difficulty, according to CXO, lies in translating the VIX-related edge into a trading system that beats a buy and hold strategy, particularly when the 5% rule calls for being in the market only about 55% of the time.

My take is that the TradingMarkets 5% rule, just like the MarketSci.com approach I outlined last week, is a valid and tradeable way to use the VIX to time the markets. For better or for worse, for now I will leave it up to readers to see how well they can use this data to develop a robust trading system that can outperform a buy and hold approach.

As Emperor Joseph II was fond of saying in Amadeus, “Well, there it is.”

10 comments:

I.L. said...

The proper metric is not whether it beats buy and hold (very few strategies do) but whether it beats a randomly generated strategy. If it does, then you have a tradable edge.

Anonymous said...

Hi,
I consider 12%+ above or below by the 10 dma to be a more effective indicator for considering highs and lows.

Bill Luby said...

i.l., I'll take a strategy that consistently outperforms the market on a risk-adjusted basis, even if it is only in the market about half the time. There are many ways to tweak the limited number of tests that the CXO Group did.

I primarily wanted to let readers know that the edge was staring them in the face and urge them to do some homework to see how they might put it to use.


Anon, your 12% number is consistent with what I am thinking and doing vis-a-vis the 10 day SMA -- and it has served me well.

Cheers and thanks to each of you for your comments,

-Bill

Trading Goddess said...

Bill,

A big thank you for pointing that little, errr, immm... "thing" out for me. I am glad I have you looking out for my welfare. :)

Bill Luby said...

Hey!

What happened, TG?!?

It *was* only a shadow!!!

I.L. said...

hey bill,
I have a question for you and if anybody can explain this "conundrum", it has to be you.
I bought some August 15 VIX puts when the VIX was near 18 a few days ago. We're now below 15 and guess what, the puts have not moved one iota. What gives?

Bill Luby said...

Hi i.l.,

Welcome to the strange land of VIX futures.

To make a long story relatively short, what you are a victim of is the backwardation that typically occurs in VIX futures when the spot VIX spikes. I like to think of it this way: because of mean reversion, a one or two day spike in the VIX in the first half of August, regardless of magnitude, is not likely to affect the assessments of most market participants of where the VIX will be on Aug. 22, when that months' options expire.

The weather analogy is apt here too: if today the temperature in New York spikes to 120 degrees, is anyone going to change their estimate of what they expect the temperature to be on Aug. 22? Probably not.

This is what makes trading VIX puts and calls that have more than a couple of days until expiration more of a futures play than a play on the spot volatility index.

In your case, if you bought puts on 7/11 when the VIX topped out at 17.91, you saw the VIX drop 1.00 yesterday, but the Aug futures drop only 0.29. Why? Because the VIX
futures were predicting an 8/22 VIX of 16.10 on 7/11 -- and one day's price action did little to change the collective thinking.

There is a graph in the first link below that provides some visual clues for what I am trying to say.

You may be interested in reading up on VIX Futures: The One Picture to Remember and VIX Futures Starter Kit for some additional background.

That's the shortish answer; I hope it helps.

Cheers and good luck with the puts,

-Bill

Bill said...

Methods for beating the market on a "risk-adjusted" basis are literally falling off of trees. If you're interested, email me for a method that keeps you in the market 66% of the time while matching the S&P 500 from Jan '66 to today. I've got another that comes pretty darn close with far fewer trades (2 per 3 years) and in-market 74%.

My vote's for generously beating buy and hold with less volatility, or stomping buy and hold in the fucking nuts with as much volatility as I can take - anything less, and why bother?

Trading Goddess said...

Bill,

As I used that pic for the "volume" of her lower half, I did not pay that close attention to the top! hehe Wow! I am hoping you were the only one who noticed before I swapped pics. whew!

I.L. said...

Thanks Bill.
I liked that chart.
Is there any way to get VIX futures chart data?

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