Why our XIV ETF volatility trading strategy works in all markets

by | Mar 4, 2016

Volatility products are very complicated instruments. They don’t derive their price based on traditional supply and demand dynamics, but instead they are calculated based on the fluctuating values of the VIX futures term structure. Sometimes the explanations for why certain strategies work can get a bit too technical, so I thought I’d give my best attempt to explain as simply as I can, why our strategy works and why it will continue to outperform in any market environment.

Let’s divide the S&P 500 market environment into three separate pieces and talk about each one:

 

Environment 1) Bull market

  • Stocks are moving higher
  • Volatility is low
  • VIX futures term structure is in contango

In bull markets when stocks are moving higher, we buy the volatility product XIV which significantly outperforms the S&P 500, and as a result we can beat the market during good times.

 

Environment 2) Bear market

  • Stocks are moving lower
  • Volatility is high
  • VIX futures term structure is in backwardation

In bear markets stocks decline, sometimes rapidly and again we don’t ever hold the S&P 500. Instead we hold an inverse volatility product called VXXΒ that tends to go up when stocks go down. This means we can also beat the market in bad times.

 

Environment 3) Neutral or flat markets

  • Stocks are chopping around but staying reasonably range bound
  • Volatility is neutral
  • VIX futures term structure is marginally in contango

This is the market environment that separates our strategy from our competitors. The majority of traders will continue taking trades based on the signals they track, even though the signals might be very close to the breakpoints.

 

For us we simply don’t trade when the signals are ambiguous. We’ve set a range of middle ground signals that are just ignored and as a result our fund spends over 50% of the time in cash. We ONLY take trades that we have high conviction in.

As they say though the proof is in the pudding. We’ve crushed the S&P 500 every year and will continue to do so.

* Include all trade fees, all ETF holding fees, and are adjusted for dividends

XIV beats the S&P in good times, VXX profits during market declines, and we don’t trade ambiguous middle ground signals so we’re safely in cash. This strategy will be successful as long as there is market volatility and a risk premium, which is a product of human nature and isn’t going anywhere.

2 Comments

  1. Wendek White

    Hello

    This is a very interesting article – thank you for sharing your knowledge about the markets!

    I would like to know why you buy the VXX and XIV. Why not just buy and sell the VIX or S&P 500 directly?

  2. Volatility

    Thanks for the comment! The answer, I do trade those as well πŸ™‚

    Trading equities has a place in a portfolio and so does direct option trading on the VIX. But the reason the XIV/VXX can also have a place in a balanced portfolio is because they are products that derive their prices in a unique way that can be predicted at a reasonably high level. With a good understanding of how it all works, as well as understanding the risks involved because there are those as well, these volatility products can be quite profitable.

    The key is managing the risk and hopefully some of my articles and videos can help you do that. If you have any other questions feel free to ask me anything, take care

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