The following is the complete three part series on the VXST:VIX ratio that we originally published on SeeItMarket.
Pt 1 - Introducing the VXST:VIX Volatility Ratio
With the lack of a buyable stock market dip dominating the financial news (see: WSJ’s “Markets’ Steady Climb in 2017 Defies Historic Odds“), many traders are waiting for an opportunity to enter the market on the long side and participate in what is shaping up to be a low volatility melt-up.
But without a pullback to make traders feel like they are getting a good deal, how can they find a good entry? And even more perplexing, are they at risk of buying at a market top?
Numerous timing methods and buy/sell indicators exist to help traders determine if a market is trending, if it is overbought and if it is at risk of pulling back. But most are derivative of price and many require some discretion.
If you’re looking for a measure of the options buying habits of actual market participants, you may want to consider the VXST to VIX trading ratio (or CBOE Short-Term Volatility Index – INDEXCBOE:VXST to CBOE Volatility Index – INDEXCBOE:VIX).
VXST / VIX Volatility Ratio Chart (with Buy Signals)
While no single market indicator or ratio can tell the full picture, the ratio of short term VIX futures (9 days) to longer term VIX futures (30 days) provides traders with a concrete, quantifiable way to understand how professionals are positioning themselves. When the mood shifts to risk off, the ratio typically pops above the 1.0 level (see green region on chart below). As volatility mean reverts, a drop below the 1.0 level often coincides with a rise or at least increased stability in the equity markets (as measured by the S&P 500 index, SPX).
Used in combination with methods, this ratio can provide traders with favorable long equity entry points. For traders that are unwilling to wait for a spike in the ratio, levels can be identified as “safe zones” to provide traders with the increased confidence that they are not buying into a market that is at immediate risk of a pullback.
Pt 2 - Backtesting The VXST VIX Ratio For Trading The S&P 500
Last week, we took a dive into a key volatility ratio that traders can use for timing equity trades.
As you can see from the chart below, a spike above 1.0 in the ratio and a subsequent move back towards 1.0 tends to coincide with a near-term low in the S&P 500 Index (INDEXSP:.INX). But to see if we can take a simple chart observation and create a viable trading program, we need to crack open the Excel and run some preliminary numbers.
A few caveats before we begin: This is not a trading system. It is simply a few math exercises to see if our entry criteria warrants further exploration. To keep the focus on the entries (which are a small element in the overall success of a trading system), we tested the signals across a range of holding times, from 5 days to 30 days. No dynamic exit logic, no scaling or position sizing, no stop levels. The results below include all trade signals, including concurrent ones (i.e., if the signal fired on day one and then again on day three, we opened both and held them for the allowed number of days). With that, let’s look at the numbers.
We started by looking at the VXST to VIX ratio from January 2014 to present. During this time, the SPY ETF climbed from 181 to 247, returning approximately 36%. If we are going to find a trading approach using this ratio, we’ll be looking for signs that we could deliver greater gains than a buy and hold approach with preferrably lower volatility. And we would need to overcome trading costs. Not an easy task.
Our first preliminary test looked at going long the SPY ETF when the VXST to VIX ratio peaks over 1.0 and then recedes back below 1.0. We then tracked the performance of the SPY position for 5, 10, 15 and 30 days. Because of the short term nature of the ratio, this initial test produced a large number of trades with a nearly equal number of negative and positive trades of similar sizes.
To smooth out the false signals, we next explored using a 3 day simple moving average rather than tracking the raw ratio value. When the 3 day MA dropped back below 1.0, we went long the SPY. This method decreased the number of trades and was profitable across all holding periods (5, 10, 15 and 30 days). The 15 and 30 day hold times exceeded the gains from buy and hold over the same period.
We ran the same test with a 5 day simple moving average and saw similar results.
With decent but not amazing results from the moving average approach, we looked for a way to identify when the ratio was just beginning to drop back down from the peak, getting us long SPY earlier than we would if we waited for the ratio to recede all the way below 1.0. So we tested a new entry method: go long SPY when the ratio climbs above 1.0 and then drops below the 3 or 5 day moving average. This allows us to go long when the ratio is above 1.0 but appears to be losing momentum.
This approach provided the best returns over the 15 and 30 day hiding periods. The 5 day MA slightly outperformed the 3 day MA in terms of win rate but the 3 day MA offered greater net gains. Getting into the trades helped most of our performance metrics.
The results from the preliminary tests are encouraging and suggest that the the VXST/VIX ratio can be used to improve entry points for long SPY positions (in a generally positive trending market environment). With the addition of smarter exits and some risk controls, we can further test the robustness of this approach.
In our next article, we will explore some other ways for traders to exploit the volatility ratio. Thanks for reading!
Pt 3 - Using The $VXST To $VIX Ratio For Shorting $VXX
This week we’ll use the ratio to identify opportunities for shorting the VIX Short-Term Futures ETN (NYSEARCA:VXX).
This week we are exploring some preliminary numbers as we test another way to capitalize on the ratio – shorting VXX. In the interest of making a direct comparison, we used the same logic to identify the peak as we did in last week’s long SPY test:
– Wait until the ratio and the ratio’s 5 day simple moving average (MA) is above 1.0.
– When the ratio moves below the 5 day MA, short the VXX ETN.
– Track the returns over 5, 10, 15 and 30 day holding periods.
– Include any concurrent trades (i.e., if the signal fires while the previous short VXX entry is still on, take the additional trade).
And like the previous articles in the series, we have to remind our readers that this is not a trading system – we are simply exploring the viability of using this ratio to build a system. Far more work would need to be done before real money put to work, particularly on the use of smarter exits. As you’ll see from the results below, the VXX is far more volatile than the SPY and requires thoughtful risk management.
Overall, the study for shorting VXX was profitable for all holding periods. The win rates and profit factors (“PF” in the table) were similar across the long SPY and short VXX tests, with stronger results coming in the 15 and 30 day holding periods. Shorting VXX had significantly larger swings in average and maximum win and loss sizes (on a percentage basis).
Over the 15 and 30 day holding periods, the average wins and max wins were nearly double the size of the average and max losses, suggesting that longer hold times allow volatility to dissipate, making the need to pick the volatility precise peak less important. This size difference was not as pronounced in last week’s SPY long tests.
While we ran our initial test on a short VXX position, a trader would want to explore other methods to short S&P index volatility. This could be accomplished by buying puts and/or selling call spreads on the VXX, depending on the desired delta exposure. A trader could go long an inverse volatility ETF like XIV or the leveraged SVXY. The use of VIX futures, options on VIX futures or SPX/SPY options offer additional ways to express a short volatility thesis, with each approach offering distinct benefits (and drawbacks).