Variance Guide Chances Premium For Furnish Forecasting

Folklore has it that VIX is a reasonable leading indicator of risk. Presumably that way if VIX is high, in addition to therefore in that place is a expert adventure that the futurity provide of the SP500 volition last negative. While I convey found simply about bear witness that this is truthful when VIX is peculiarly elevated, enjoin inwards a higher house 30, I don't know if anyone has established a negative correlation betwixt VIX in addition to futurity returns. (Contemporaneous VIX in addition to SP500 levels create convey a really prissy linear human relationship amongst negative slope.)

Interestingly, the province of affairs is much clearer if nosotros examine the Variance Risk Premium (VRP), which is defined every bit the difference betwixt a model-free implied volatility (of which VIX is the nearly famous example) in addition to the historical volatility over a recent period. The human relationship betwixt VRP in addition to futurity returns is examined inwards a newspaper by Chevallier in addition to Sevi in the context of OVX, which is the CBOE Crude Oil Volatility Index. They convey found that in that place is a statistically pregnant negative linear human relationship betwixt VRP in addition to futurity 1-month unsmooth crude oil futures (CL) returns. The historical volatility is computed over 5-minute returns of the nearly recent trading day. (Why v minutes? Apparently this is long plenty to avoid the artifactual volatility induced yesteryear bid-ask bounce, in addition to curt plenty to genuinely sample intraday volatility.)  If you lot believe inwards the prescience of options traders, it should non surprise you lot that the regression coefficient is negative (i.e. a high VRP predicts a lower futurity return).

I convey tested a elementary trading strategy based on this linear relationship. Instead of using monthly returns, I role VRP to predict daily returns of CL. It is really similar to a mean-reverting Bollinger ring strategy, except that hither the "Bollinger bands" are constructed out of moving get-go in addition to tertiary quartiles of VRP amongst a 90-day lookback. Given that VRP is far from usually distributed, I idea it is to a greater extent than sensible to role quartiles rather than measure deviations to define the Bollinger bands. So nosotros purchase a front end contract of CL in addition to concur for simply 1 twenty-four hours if VRP is below its moving get-go quartile, in addition to curt if VRP is inwards a higher house its moving tertiary quartile. It gives a decent average annual provide of 17%, but functioning was misfortunate inwards 2013.

Naturally, i tin crusade this elementary trading strategy on the E-mini SP500 futurity ES also. This time, VRP is VIX minus the historical volatility of ES.  Contrary to folklore, I respect that if nosotros regress the futurity 1 twenty-four hours ES provide against VRP, the regression coefficient is positive. This way that an growth of VIX relative to historical volatility really predicts an growth inwards ES! (Does this hateful investors are overpaying for set options on SPX for portfolio protection?) Indeed, the contrary trading rules from the inwards a higher house plough over positive returns: nosotros should purchase ES if VRP is inwards a higher house its moving tertiary quartile, in addition to curt ES if VRP is below its moving get-go quartile. The annualized provide is 6%, but functioning inwards 2013 was too poor.

As the authors of the newspaper noted, whether or non VRP is a potent plenty stand-alone predictor of returns, it is in all likelihood useful every bit an additional component inwards a multi-factor model for CL in addition to ES. If whatever reader know of other volatility index similar VIX in addition to OVX, delight create percentage amongst us inwards the comments section!

===

My online Backtesting Workshop volition last offered on Feb 18-19. Please visit epchan.com/my-workshops for registration details. Furthermore, I volition last pedagogy my Mean Reversion, Momentum, in addition to Millisecond Frequency Trading workshops inwards London on March 17-21, in addition to inwards Hong Kong on June 17-20.