XIV ETF Volatility Trading Strategies Part 3 – Mean Reversion

by | Nov 3, 2013

 

* I’ll update the charts and commentary in these very old articles every now and then so that the data is stretched over longer periods of time *

In this series of five posts I’m going to be going into a little more detail about some of the most common methods of trading the various volatility ETP’s such as XIV and VXZ. This is not a teaching website, but I think it’s important that subscribers at least have a basic understanding of the complexity of these products as well as some of the potential drivers of possible strategies. The five part series will cover:

VIX Term Structure
Volatility Risk Premium (VRP)
Mean Reversion
30-day Constant Maturity
VIX : VXV Ratio

 

Part 3: Mean Reversion

A simple definition of mean reversion says that prices tend to eventually move back towards the average. Now individual stocks and even indexes don’t necessarily mean revert because they change and evolve over time, however one index that does show fairly strong mean reversion properties is the VIX Index. And since the VIX index to a certain extent is at the heart of most volatility trading strategies, it’s natural to assume that these strategies themselves can benefit from applying mean reversion techniques.

One simple method traders use to apply mean reversion is to track a ratio of the exponential moving average compared to a simple moving average. Since an exponential moving average reacts quicker and is more weighted towards what’s currently happening, the theory goes that this crossover point can be used to predict future price movements in XIV.

  • As the VIX moves higher it increases the chances of future movements lower towards the mean and should provide a tail wind for the XIV.
  • As the VIX moves lower it increases the chances of future movements higher towards the mean and should provide a tail wind for VXZ.

So let’s see how this theory actually performed in the real world:

 

That’s not very good at all, what happened?  It seems that while the VIX index definitely does mean revert, the XIV and other volatility products don’t seem to.

In order to understand why mean reversion strategies perform so poorly during market downturns, you have to conceptualize what’s actually happening.  As markets fall, volatility and the VIX index moves higher.  Mean reversion states that the chances of it coming back down are increasing so you keep holding the XIV through the small downturn.

However, what if a small sell off turns into a medium sized sell off?  Doesn’t that mean that the VIX keeps going higher?  If the chances of it mean reverting before were high, they are now higher so you keep holding the XIV through the medium downturn taking losses along the way.  And if that medium sell off turns to a major one?  That’s right, you keep holding the XIV through the entire sell off.

 

Mean reversion works until it doesn’t.  As Warren Buffett famously stated, “markets can stay irrational longer than you can stay solvent.”  You can take portfolio melting losses holding the XIV waiting for mean reversion to kick in, and when it finally does you may not have any capital left to ride the reversion back up.

 

At Volatility Trading Strategies we don’t use mean reversion indicators at all.  They are completely counterintuitive to what we are trying to achieve.  Our goal is to smooth out results over time and eliminate as many of the bad holding periods as we can, not increase the odds of us holding on to a falling knife.  For reference, here is our results again:

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