The Band, Elwood, The Band
Well, we spend alot of time trying to disabuse everyone from lazy volatility analysis along the lines “20 VIX is cheap” without any context. Clearly a system that involves some sort of Moving Average analysis is preferable, such as the most famous one that says you buy the market when the VIX gets 10% above i’t 10 Day MA and sell it when it gets 10% below.
But that one I find is more guide than rule. And I look at it almost backwards. Instead of using it as a buy or sell signal, I use it as a general health gauge for the market. In other words, if the market consistently fails to bounce when the VIX gets overbought, it’s a pretty bad sign for the intermediate trend, stuff like that.
But what if you refine the metrics a bit, will it gives better directional signals? Jared at Condor Options takes a stab with the BB Bands.
One thing we found is that the standard Bollinger settings (20 period, 2 sigma) weren’t helpful at all. As Bill Luby has pointed out before, indicator inputs are made to be fiddled with, not adhered to! So we optimized a bit, and ended up with a shorter time horizon - the prior 12 days - and somewhat narrower band settings - 1.1 deviations up, 1.8 deviations down. In our test, the system buys (sells short) one contract of S&P 500 futures whenever the $VIX crosses above (below) and then closes beyond its upper (lower) band, and exits when $VIX closes below (above) its 12 day moving average.
And the results?
Going back 5 years, the results are quite positive. Some highlights: this system is only in the market about 50% of the time, but is active enough, averaging 3.76 trades per month. With a profit factor of 2.44 (the ratio of gross profits to losses), and a winning percentage of 66%, there’s some solid positive expectancy here. One of the only unpleasant aspects is the longer hold time and relatively high number of consecutive losers - only an automated system or very disciplined trader will enter that seventh trade after taking 6 consecutive hits.
Going further, he adds the condition that you exit the trade when the VIX crosses back over the midline, you exit either way.
But truthfully, it’s the principle he’s after here, not the specifics. In other words, I would not trade this system religiously. But it is a good confirmation that the whole VIX Mean Reversion we all yap about really has some merit
