The Quest To Outperform The Market

Chances are, if you're an active trader in this market you are struggling to make money. In reality it's a tough game, one in which hedge funds and mutual funds constantly underperform the market.  In 2012, 88% of hedge funds and 65% of mutual funds underperformed the S&P 500 benchmark. In 2013, the hedge fund average trailed the S&P 500 for the fifth straight year with a 7.4% return, 23 percentage points below the S&P 500.

Why do so many professionals and individual investors lose money? Because in order to be successful in trading you need both a good plan and the discipline to execute against the plan. Without both of these a trader will fail to make money consistently.

While we can't really help you with the discipline, we can help you with the plan. We focus most on trading two securities, VXX (the "volatility futures fund") and XIV (the "inverse volatility futures fund"), based on the direction of the fund's built-in Bias. The Bias is our proprietary way of measuring the current directional force on the fund and is primarily based on the price structure of VIX futures and the internal mechanisms that the funds use to manage their holdings. As these values change each day we measure and report on the Biases in our Daily Forecasts so that we know both their direction and magnitude.

With that information, we apply the simple strategy of buying XIV when the VXX Bias is negative, or buying VXX when the VXX Bias is positive. Trading in the direction of the Bias is critical since it can impact the price of the fund by as much as 10% per week. Trading in the direction of the Bias allows traders to take advantage of the funds structure and can provide an edge in trading.

Over the past couple years, XIV has become a popular fund to own with annual returns of 142% and 85% in 2012 and 2013, respectively. But this is not a fund to buy and hold since it is prone to 80%+ losses if the Bias reverses (see XIV: When a "Sure Thing" Goes Bad). You can see in the table below that while the average annual return of XIV is 46%*, it experienced several ugly years when there was an unfavorable Bias. Rather than suffer through these losses, XIV can be sold whenever the VXX Bias is positive to help reduce drawdowns. This "Negative VXX Bias" strategy has been shown to substantially outperform XIV in 6 of the past 8 years, with an average excess performance of 48 percentage points (far right column, below).

% Gain / Loss By Year
YearXIV"Negative VXX Bias" Strategy"Positive VXX Bias" StrategyExcess performance over XIV using "Negative VXX Bias"

A look at each year's performance of the "Negative VXX Bias" strategy shows that while it is still vulnerable to losses, overall the strategy has done exceedingly well compared to the alternatives. A comparison of the annual returns of XIV vs the "Negative VXX Bias" strategy is better visualized below.

You can get a feel for how the strategy performs on a day-to-day basis by looking at the each of the performance data files (**links located at the bottom of this post). In these files you can view a graph of the daily value of a portfolio employing each strategy. The chart below compares the "Negative VXX Bias" strategy to XIV during 2011. Note the flat blue line which illustrates that XIV was not owned in the "Negative VXX Bias" strategy during the time XIV experienced steep losses because there was a positive VXX Bias.

The performance data files also contain the forecast VXX Bias values, entry and exit points, and gain/loss data including a histogram of trades. Below is a summary of trades each year for the "Negative VXX Bias" strategy.

Number Of Trades Per Year For Negative VXX Bias Strategy
Year# of TradesWinnersLosersAvg Trade Gain/Loss

Given the size of gains & losses I've discussed so far it should be clear that these strategies typically align with traders who have a relatively high tolerance for risk. They are not for everyone and they are certainly not for anyone who does not pay attention to the changing Bias of the funds. However, if you're a trader who has decided that these types of funds are right for you, we would love to provide you with the tools to assist in your analysis and decision making process.

In addition to tracking these Biases on our website, we can also send email alerts to let subscribers know when the VXX Bias has changed direction. To learn more about the services we provide you can check out our Subscribe page, or drop us a line via the Contact page. You can also chat with us on Twitter at @tradevolatility if you like. We're here to help and answer any questions you might have about the world of volatility!


*Daily prices for VXX and XIV prior to fund inception have been derived from existing VIX futures data. Backtests use each security's 4:00pm ET closing value as an approximated trade price for indicators that require VIX and VIX futures to settle at 4:15pm ET.

**Data files: 20062007200820092010201120122013, 2014

Hypothetical and Simulated Performance Disclaimer
The results are based on simulated or hypothetical performance results that have certain inherent limitations. Unlike the results shown in an actual performance record, these results do not represent actual trading. Also, because these trades have not actually been executed, these results may have under- or over-compensated for the impact, if any, of certain market factors, such as lack of liquidity. Simulated or hypothetical trading programs in general are also subject to the fact that they are designed with the benefit of hindsight. No representation is being made that any account will or is likely to achieve profits or losses similar to these being shown. Additional performance differences in backtests arise from the methodology of using the 4:00pm ET closing values for XIV, VXX, and ZIV as an approximated trade prices for indicators that require VIX and VIX futures to settle at 4:15pm ET.

. . . . . . . . . . . . . .

Stay up to date by having posts sent directly to your RSS feed or Email.