Our VRP+VXX Bias Indicator +35% in 1st Quarter

The first quarter of 2015 has come to a close and investors everywhere are reviewing their performance. This is the perfect time to evaluate the effectiveness of your investment strategies and to make adjustments accordingly.

Our VXX Bias and VRP indicators have both navigated the first quarter quite well, at +31% and +29% YTD, respectively. These two indicators each provide end-of-day signals for placing swing trades in XIV and VXX (if you're not already familiar with our trading strategies you can learn more about them here). 

Our preferred strategy, VRP + VXX Bias, combines the two signals to place trades only when they agree on direction and is +35% YTD.

The graph below tracks the daily values for each of our indicators as well as XIV (buy-and-hold) as a comparison reference point (the usual investment benchmark, the S&P 500, is not included because it is an irrelevant +0.9% YTD).

We kept commission fees low by placing only a half dozen trades in the first quarter. Trade statistics for each strategy are summarized as follows**:

If you're not quite meeting your investment objectives this year perhaps we can help. For less than $3 per day we provide subscribers access to all of our VIX data & metrics, our indicators, automated Bias change alerts, and the members' forum.


--> New in 2015, we will be providing an additional level of visibility into our trading by having our performance verified by a third party (Marketfy). We recently tweeted our YTD portfolio performance of +17.8%, which was obtained by using the VRP+VXX Bias strategy as our guide. Look for additional updates on real-time notifications of our trades in the future.

**For those interested in additional detail, the daily history of indicator values that have been emailed to subscribers in 2015 can be found in the data sheet links below:
- VXX Bias: 2015
- VRP: 2015
- VRP+VXX Bias: 2015

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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 approximated trade prices for indicators that require VIX and VIX futures to settle at 4:15pm ET.

Why (and exactly how much) Your Leveraged ETF Will Underperform

Experienced investors know that owning leveraged ETFs (2x and 3x) leads to decay in the value of the funds. The decay can be so strong that even if you get the direction right you may still end up with a loss. In this post I will quantify the decay on leveraged ETFs to illustrate the dangers of holding these funds.

As a brief bit of background, leveraged ETFs seek to return the 2x or 3x the daily return of the underlying security. Below are some examples:

NUGT: Returns 3x the daily return of Gold Miners ETF (GDX)

DUST: Returns -3x (inverse) the daily return of Gold Miners ETF (GDX)

TNA: Returns 3x the daily return of small cap stocks (IWM)

TZA: Returns -3x (inverse) the daily return of small cap stocks (IWM)

UVXY: Returns 2x the daily return of a blend of 1st and 2nd month VIX futures (VXX)

There is actually a known formula (**fellow math nerds can see the formula at the end of this post) for the return of a leveraged ETF. The critical variables that dictate leveraged ETF performance are:

1) The return of the underlying index (e.g. GDX, VXX, IWM)

2) The actual volatility of the underlying index

3) The amount of leverage (e.g. 1x, 2x, 3x)

4) The duration of the holding period

In quantifying the decay of these 2x and 3x ETFs I will start by mapping out #2, which is the actual volatility of the underlying index.

1) GDX: Actual volatility (HV20) range: 20 - 80

2) VXX: Actual volatility (HV20) range: 20 - 130

3) IWM: Actual volatility (HV20) range: 10 - 40

Using this information we can build tables and graphs to capture the various scenarios for the return of the underlying and compare that to the return of the leveraged ETF. (Note: All scenarios below assume a holding period of 3 months. Holding a fund for less than 3 months will see relatively less decay, while holding longer will experience greater decay.)

The return of the underlying index is listed in the first column while the various volatility rates are listed in the top row. The intersection of the index performance and its volatility rate gives the return of the leveraged ETF.

1) NUGT

For example, if GDX returned 5% over the holding period and had a 20% volatility rate, the return of NUGT would be 12.3%. Another scenario would be a holding period return in GDX of -12.5% and a volatility of 60%. This results in a return of -48.9% in NUGT. Note that cells colored red indicate that the leveraged ETF is underperforming 3x of the underlying index, while green cells are outperforming. It should be clear from the above that under most scenarios except for when actual volatility is low, a 3x fund will underperform.

The scenarios in graph above can be drawn in graph form for better understanding. The horizontal axis marks the return of the underlying index (GDX, IWM, etc) and the vertical axis marks the return of the leveraged ETF.

NUGT & TNA:

Leveraged inverse ETFs (DUST & TZA):

UVXY:

Because UVXY is only a 2x leveraged fund we a need different chart. However as shown above, the actual volatility of VXX is much higher as well which changes other input ranges.

The resulting concept is the same however: the higher the actual volatility of the underlying (VXX), the more UVXY will underperform. 

Consider someone who expect the market to crash while VIX spikes 80% and VXX spikes 60%. If the underlying volatility of VXX is 80% (which is likely to happen during market crash), UVXY only returns 12.7%. If VXX returned 80% but the actual volatility of VXX is 110% (it saw 120% in fall of 2011), the UVXY return is only -2.3%. Obviously UVXY is a very poor hedge to hold for any significant duration. It is really only beneficial for short duration trades if you have impeccable timing.

Here are the UVXY returns in graphical format:

Don't be lured by the potential return of these leveraged ETF products. Unless actual volatility of the underlying index is very low, you're likely to be just another victim of leveraged ETF decay.

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** Return (R) for a leveraged ETF is defined by:

Where x is the leverage ratio, σ is the volatility of the index, and T is the time period the investment is held (source Cheng and Madhavan (2009) and Wang (2009))

Utilizing Two Complementary Strategies to Trade VXX & XIV

In early December we made a second strategy for trading VXX and XIV available to our subscribers: the Volatility Risk Premium (VRP) strategy. You may remember me outlining the excellent performance of this strategy in my previous blog post, Volatility Strategies - Separating Fact From Fiction. I liked the strategy so much I decided to make a few adjustments and launch our own version of VRP to use along with our VXX Bias on our Daily Forecast page.

Why use two strategies for trading volatility ETPs? Because no single strategy is perfect and the market is inherently unpredictable. Using two complementary strategies simultaneously compensates for inherent weaknesses within each of the strategies, reduces drawdowns, and smooths out returns over months and years.

The VXX Bias and VRP strategies each take a very different approach for maximizing gains. The VXX Bias strategy is based on the term structure and momentum of VIX futures, while VRP is based on the price of VIX and historical volatility measurements. However, each of these strategies thrive and struggle depending on the specific market conditions. For example, the VXX Bias strategy has an advantage in handling periods of moderate drawdowns and sustained periods of backwardation. Meanwhile, the VRP strategy tends to be better with choppy markets and periods of gradually increasing volatility when VIX futures are in contango. 

You can see in the backtest results below that neither strategy consistently outperforms the other over a given year, although both VXX Bias and VRP are vastly superior to a buy-and-hold approach with XIV. 

As you can see in the chart above, using the VRP and VXX Bias strategies together (the green columns) provide more consistent returns than using just one strategy alone. In most years the "VRP + VXX Bias" strategy return falls roughly halfway between the VXX Bias and VRP strategies used on their own.  (Note: There are a couple ways to incorporate two strategies, but the easiest way is to trade in VXX or XIV only when they agree on the trade direction, which is how the above results are generated.)

Looking at the strategy statistics below, we see that the VRP + VXX Bias strategy benefits from a reduced maximum drawdown and a 0.90 Sharpe Ratio. 

Other relevant stats for trading only when VRP and VXX Bias agree on direction (years 2004-2014):

- # of trades: 191

- Avg hold time: 9.8 days

- # of days out of market in cash: 821 (out of 2711) --> 30%

- Avg trade return: 5.35%

- Max trade gain: 110.8%

- Max trade loss: -20.3%

The equity curve for each of the strategies (below) illustrates the smaller drawdowns and improved performance of using VRP and VXX Bias together:

Table of annual returns for the above data:

Full test data for both the VRP and VXX Bias strategies can be found in the spreadsheets at the bottom of the Subscribe page. You can also read more about our trading strategy on our Strategy page.

Access to our daily indicators and automated alerts for both the VRP and VXX Bias strategies is available via subscription to Trading Volatility+. 


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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 approximated trade prices for indicators that require VIX and VIX futures to settle at 4:15pm ET.

2015 CBOE Risk Management Conference - Attendees get 30% off Subscription to Trading Volatility+

CBOE's Risk Management Conference is the premier educational forum for users of volatility products and equity derivatives. It is *the* conference for financial professionals to attend to learn the latest risk management tools and tactics from top traders and strategists. 

The next CBOE Risk Management Conference is scheduled for March 4-6 in Carlsbad, California. The agenda is now set with talks from over two dozen industry experts, exploring the latest products, trading strategies and tactics used to manage risk exposure and enhance yields. The full agenda is available here.

As an added bonus, attendees at the March 4-6, 2015 session are able to get a 30% discount* on their first three months of a Trading Volatility+ subscription. 

Our Trading Volatility+ service provides access to:

• Our full suite of volatility metrics and indicators to bring you valuable insight into the movement of VIX ETPs, 
• Our strategies, which utilize variations on widely-used trading indicators (such as Volatility Risk Premium) as well as our own proprietary algorithms (VXX Bias^TM and ZIV Bias^TM),
• Our automated alerts which notify subscribers whenever one of our indicators experiences a critical change in direction, making the strategies easy to follow,
• Our members' forum where you can interact and share ideas with other volatility traders. 

The unique characteristics and profit potential of VIX futures led to the fifth consecutive annual trading volume record in 2014. 2015 is already looking to break that record again as interest in volatility as a tradable asset continues to grow. If you're still shying away from this well-kept secret of sophisticated investors, now is is the time to learn more. A good place to start is with our concise (and FREE!) e-book, Fundamental Concepts and Strategies for Trading Volatility ETPs.

*Discount available only to new subscribers. The discount will be refunded to subscribers after providing proof of event attendance.

Volatility Strategies - Separating Fact From Fiction

Earlier this year I came across the website Volatility Made Simple. Much like our goal at Trading Volatility, Volatility Made Simple's goal is to help less informed investors understand and take advantage volatility ETPs in a manner that is similar to how large institutions trade volatility.

What is really great about Volatility Made Simple, is that at the end of each month the performance of various volatility trading strategies is recorded. As of the November update there were twenty different strategies on the list, and according to him, they represent the vast majority of volatility trading strategies of traders timing these products.

Below is his image which illustrates the November performance of strategies compared to XIV buy-and-hold.

The other nice thing is that he will occasionally write posts which independently examine each strategy in depth, identifying the exact trading rules and performing backtests to 2004 to see how they perform under a variety of conditions. This is useful to make sure that a strategy is not just optimized for ideal markets but can also perform well in more turbulent environments. In addition he also provides statistics such as percent winning/losing trades, average trade return, and sometimes the max drawdown percentage and Sharpe ratios. Below I will post several of the charts from his site.

It gets interesting looking at the ten year returns of these strategies. Looking at VIX & More's (by Bill Luby) VIX:VXV ratio strategy, we can see that a portfolio of $10,000 in 2004 grows to a portfolio of over $1,200,000 by February 2014 when following these rules. Chart below:

From $10,000 to $1,200,000 -- that's a a 12,000% return in 10 years! That's remarkably impressive.

A similar strategy offered by Market Sci, the Mean Reversion Strategy, takes our portfolio of $10,000 in 2004 grows to a portfolio of over $1,200,000 as well, although it takes a slightly different path to get there. Chart for Market Sci's below:

Then there is Trading the Odds's Volatility Risk Premium strategy which boasts growth of $10,000 to over $5,000,000 (50,000% gain) over the same time frame, beating Market Sci's returns by a factor of five:

And if that return isn't enough, there's the Optimized VRP Strategy, which fine-tunes backtested performance to turn a portfolio of $10,000 to over $10,000,000 in 10 years. This strategy is achieved with an average of just eight trades per year. Chart below:

Wow. So should we be issuing a scam alert? A 100,000% return over 10 years?!? GET REAL!! Too good to be true, right?

Except that these strategies are all valid. The average investor who just buys index ETFs or scours the stock market looking for the hottest stocks in a struggle to outperform the S&P 500 (or just break even) will completely dismiss these returns as impossible. But for me, VIX and More, Market Sci, Trading The Odds, Volatility Made Simple, and all the other people who have developed one of these volatility strategies, these returns are real (Note: None of these people are aware that I'm writing this, they have no connection with the Trading Volatility site, and do not necessarily agree with or endorse anything I'm writing). 

How do I know that these ridiculous returns are likely to be legit without independently verifying them for myself? Because our VXX Bias strategy is right in the ballpark with the leaders (performance summary for our VXX Bias strategy can be found here).

When you look at the return over the entire period it seems astronomical. But actually this just demonstrates the power of compound interest. A portfolio of $10,000 that grows at 90% per year over 10 years is worth $6,131,066.26, which is roughly what the best strategies return. The trick is being able to average 90% per year while avoiding major drawdowns.

When I tell people about my strategy and the returns that can be achieved, everyone skeptically asks, "Why aren't other people doing this?" The answer is "THEY ARE!" 

Volatility Made Simple tracks a handful of strategies that have been made public. From what I can tell, and as VMS points out, most of the strategies apply similar concepts. Each strategy has its own strengths and weaknesses and many struggle through the same conditions. Because of certain optimizations, some strategies manage to excel over shorter time frames under certain conditions. However, over the years it's easier to see the order of magnitude of difference among the different strategies. I'd argue that a blend of two or three of the top strategies would be the best way to reduce variation in returns, however this may not be cost-effective for smaller accounts.

There are many other confidential volatility strategies out there. They belong to the smart money managers and institutions who are making money hand over fist. And the best part is that it doesn't matter if it is a bull or bear market. 2008 financial crisis? Not a problem -- in fact, a good strategy flips to buy volatility to take advantage of a steep market decline.

The fact is, volatility ETPs are generally giant scams designed to separate unknowing investors from their money. VXX and UVXY are obviously horrible over the long term but can go up 10x in a matter of months. Inverse volatility (XIV) looks good most of the time but is prone to 80%+ drawdowns that can wipe you out. People who understand how these products work can exploit their flaws to generate giant returns. 

For people trading volatility ETPs at a loss or barely getting by, you have a problem. Given the amount of free and paid resources out there, there's no excuse for this. Here are some things you may want to consider:

1) Find a signal-based trading plan that matches your style and fits in with your financial objectives. Make sure the strategy has signals that make it easy for you to follow.

2) Strictly trade based on hard rules. This will allow you to avoid making emotional decisions and fighting the trend, and will maximize long-term results.

3) Understand that day-to-day, week-to week, and month-to-month performance can result short-term negative returns. Don't lose focus of the long term.

4) You will have losing trades. This is why we focus on process and probabilities, not short-term outcomes. What matters is the process and patience.

5) If you are not able to follow rules, don't trade. Sorry to say, but if you can't find the discipline you don't get the profits (and you probably shouldn't be trading at all).


(It also helps to understand how VIX ETPs work. For an overview you can read my free eBook, Fundamental Concepts and Strategies for Trading Volatility ETPs.)

Most of the strategies on VMS's summary are similar in that they assess market conditions at the end of each trading day to determine if a buy or sell is necessary. They are also similar in the number of trades per year, typically between 7 and 30, making these strategies fairly manageable swing trades which do not require the investor to be glued to a trading screen all day.

When it comes down to it, I don't really care which strategy you choose as long as you are successful. It's just time to stop being one of the many unfortunate who are on the wrong side of the trade.

If you'd like more information on the Trading Volatility Bias strategy please visit this link. Our Bias indicators are automatically emailed at the end of each trading day and our Bias change alerts notify subscribers whenever the Bias changes direction, making it easy to follow. Our subscriber services are available for less than $3 per day making it very affordable.

You can also take advantage of our free VIX Futures Data pages as well as our SPY Arbitrage and Pivot Point tools. And if you have any questions at all, feel free to reach out to me via the Contact page.




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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 approximated trade prices for indicators that require VIX and VIX futures to settle at 4:15pm ET.