TRADING VOLATILITY: PART TWO: CAPTURING THE VRM

By Andrew Gibbs, Daniel Adams and Alex Kowalski

Last week, in part one of this article, we introduced Volatility, a tradable asset class
unexplored by most traders. We explained what Volatility is and how it gives rise to an inherent
Volatility Risk Premium (VRP) a premium collected by volatility sellers for taking on risk. This
week, in part two of this article, well expand on why the VRP should be of concern for traders,
and most importantly, how we can practically trade and profit from Volatility.
Why Care About Volatility?
As traders we are always looking for an edge over the market an attribute or
circumstance we can exploit. It just so happens that Volatility has the tendency to be mean
reverting i.e. extreme values are more likely to be followed by less extreme values. Volatility, in
theory, cannot drop to zero as there are always fluctuations in the markets. Thus this behaviour
makes Volatility predictable (predictable = potential edge). By simply waiting for extremely low
or high periods of Volatility, we can apply a strategy that captures any move that reverts back to
the mean from these extreme levels.
As proof of this predictability, a simple mean-reversion trading strategy based on moving
average crossovers produces the results shown in figure 1 below. The annualized return for the
strategy has been 215% since 1990.

Figure 1.0:
Equity curve demonstration of a hypothetical mean reverting strategy on the VIX
(Tony Copper, Easy Volatility Investing).

The return is considerable but since the VIX is not tradable, this particular return is not
realizable.
Volatility Instruments ETNs
So how do we trade practically trade volatility in the real world? The answer: Exchange
Traded Notes (ETNs).
For those who are not familiar with ETNs, theyre simply debt instruments traded on an
exchange, in much the same manner as a stock is traded. ETNs are designed to track an
underlying index or benchmark, giving investors access to the returns of the tracked benchmark.
ETNs are issued by an underwriting bank. When an investor buys an ETN, the underwriting
bank promises to pay the amount reflected in the index, less investor fees. The risk then
associated with ETNs is if the underwriting bank were to go bankrupt and the investment to lost
value. The ETNs traded by our system are extremely popular, with very large daily volumes.
The volatility systems we are going to outline trade the following two ETNs:
- VXX is the iPATH S&P 500 VIX Short-Term Futures ETN issued by Barclays.
- XIV is the Daily Inverse VIX Short-Term ETN issued by Velocity Shares.
Both the VXX and XIV are traded on the American Stock Exchange (AMEX) and are based
on the value of the S&P 500 VIX Short-Term Futures Index.
For practical purposes, it is easier to take long positions (to buy) in an ETN than to take
short (to sell) positions. For instances where we wish to go long volatility we buy VXX, while if
we wish to be short volatility we buy XIV, since XIV tracks the inverse VIX Short-Term Futures.
Contango Indicator
We know from the existence of the VRP that the market tends to overestimate future
volatility compared to actual volatility. Within the futures market, this concept is known as
Contango a situation where the futures price of the VIX is higher than the expected spot price.
To visually plot this phenomenon, we use our Contango indicator (shown in green in
figure 2.0 and 4.0). The formula for this indicator is shown below:
Contango Indicator = 10 Period Moving Average of (Close of $VXV Close of $VIX) where
$VXV = CBOE S&P500 3-month Volatility Index and VIX = CBOE Market Volatility Index.
Thus in general, we buy VXX when volatility rises (stock market generally falling and the
contango indicator is below zero) and buy XIV when risk and volatility reduce i.e. typically when
the stock market is rising and the Contango indicator is above zero.
The XIV System
The XIV system is a medium term trend-following trading strategy and is designed to
capture the inherent volatility risk premium. Figure 2.0 shows the chart configurations as well as
the buy and sell signals generated by the XIV system. Solid dark green lines indicate winning
trades, while solid red lines indicate losing trades. As shown on the chart, trades are entered
when our Contango indicator is above zero (green) and XIV experiences a fall after the
Parabolic Stop and Reverse trailing stop reverses above price (shown by green boxes). Trades
are closed out immediately when the stop reverses again.

Figure 2.0

XIV daily chart showing the trades placed by the XIV system.

As we mentioned earlier the Vix has a mean reverting nature which we take advantage
of with this trading method. Firstly as weve just said we use the Contango indicator to set the
longer term trend. We then look for a counter trend move. For this model we simply wait for
price to be trading below the Parabolic SAR. When this occurs the exact entry method can be a
number of different things. A simple entry mechanism could be to utilise the RSI indicator with a
short term time frame, example 3 or 4 periods and wait for this to trade below 25 representing a
short term oversold market and then an entry can be taken the next day on the open. This is
nice and simple and very effective, but can often be early. A stop loss of 20% can be used or
simply close for a loss if the Contango indicator turn to red without using a stop loss, meaning
the Vix futures move into a period of backwardation.
For our exit we simply wait for price to begin trading above the Parabolic SAR, if price touches
the Parabolic during the trading session we simply exit the next bar on the open.

The trading results for the XIV system are shown in table 1.0 and the equity curve in
figure 3.0. This system displays exceptional results with a win rate over 85%, a high average
trade size of around $2000 (on a $10,000 trade size) and an extremely high profit factor. The
system trades on average 5-7 times per year. Bear in mind there is limited history with this
backtest as the VIX only started trading in 2010, however with a little extra effort the same
method can be tested on the Vix itself (switching long trades to short trades and vice versa) so
that you can backtest the method back to 2004.

Table 1.0

Results (hypothetical) for the XIV trading system from 2011.

We update the data for our XIV system daily and provide buy and sell signals based on this
system, contact Halifax New Zealand or sign up to free 60 day trial of our signal service.

Figure 3.0

Equity curve for the XIV system.

The VXX System

The VXX system is designed to capture the rapid rises in volatility that occur when
market risk rises and the stock market falls. Figure 4.0 shows the chart configuration and the
buy and sell signals generated by the VXX system. Trades are entered into when our Contango

indicator is below zero (red), and are closed out when the Contango indicator goes back above
zero (green). Its really that simple but has the potential to make large profits in bear markets.
The system only trades on average 1.3 times per year with a low win rate. The trading
results for the VXX system are shown in table 3.0 and the equity curve in figure 6.0. This may
not seem too exciting but it does capture some very good trades when fear levels rise, such as
in the recent market drop in 2008. The system also works well in conjunction with the XIV
system which trades more often when volatility is falling and the market is rising. For more
information on our VXX system, contact Halifax New Zealand or sign up to free 60 day trial of
our signal service. We should also point out that we have tested this method on the VIX futures
going back to 2004 as sample size on XIV and VXX starting in 2010 is far too small for a
realistic backtest.

Figure 4.0

VXX Daily Chart showing the trades placed by the VXX system.

Figure 5.0

Equity curve for the VXX system.

Table 3.0

Results (hypothetical) for the VXX trading system from 2009.

Given the high volatility of returns traders should really only allocate 20% or less of their
portfolio to this strategy as overnight moves of 10% or more are not uncommon.
Conclusion
Overall, we have outlined two easy to implement and historically incredibly profitable
volatility trading strategies. These strategies are suited to trading accounts of all sizes as both
strategies trade on very liquid ETNs with high average trades, making the impact of brokerage
minimal. For more information on any of the strategies presented in this article, or for help with
implementing the strategy please contact any of the authors below by visiting
www.halifaxonline.co.nz
Andrew Gibbs is the director and head trader for Halifax New Zealand a full service
brokerage offering broker assist and managed systems across Equities, Futures, Options and
Forex.