Volatility Trading Strategy, a System Based on Volatility Risk Premium

Last year, we presented backtested results for a VXX trading strategy. The system’s logic is based upon the concept of volatility risk premium. In short, the trading rules are as follows:

Buy (or Cover) VXX  if VIX index <= 5D average of 10D HV of SP500

Sell (or Short) VXX  if VIX index > 5D average of 10D HV of SP500

The strategy performed well in backtest. In this follow-up post, we look at how it has performed since last year.  The Table below summarizes the results

All trades Long trades Short trades
Initial capital 10000 10000 10000
Ending capital 3870.55 9095.02 4775.53
Net Profit -6129.45 -904.98 -5224.47
Net Profit % -61.29% -9.05% -52.24%
Exposure % 100.00% 14.67% 85.33%
Net Risk Adjusted Return % -61.29% -61.68% -61.23%
Annual Return % -60.50% -8.86% -51.48%
Risk Adjusted Return % -60.50% -60.42% -60.33%
All trades 11 5 (45.45 %) 6 (54.55 %)
 Avg. Profit/Loss -557.22 -181 -870.74
 Avg. Profit/Loss % -3.35% -4.40% -2.47%
 Avg. Bars Held 24.55 8.6 37.83
Winners 6 (54.55 %) 2 (18.18 %) 4 (36.36 %)
 Total Profit 2366.97 365.38 2001.59
 Avg. Profit 394.49 182.69 500.4
 Avg. Profit % 13.75% 6.46% 17.40%
 Avg. Bars Held 32.5 7.5 45
 Max. Consecutive 2 2 2
 Largest win 1308.08 239.26 1308.08
 # bars in largest win 102 8 102
Losers 5 (45.45 %) 3 (27.27 %) 2 (18.18 %)
 Total Loss -8496.42 -1270.36 -7226.06
 Avg. Loss -1699.28 -423.45 -3613.03
 Avg. Loss % -23.87% -11.64% -42.21%
 Avg. Bars Held 15 9.33 23.5
 Max. Consecutive 2 2 1
 Largest loss -6656.33 -625.51 -6656.33
 # bars in largest loss 29 11 29

The strategy produced 11 trades with 6 trades (55%) being winners. However, it suffered a big loss during August. The graph below shows the portfolio equity since last August.

quantitative trading volatility
VRP volatility trading strategy

Large losses are typical of short volatility strategies. An interesting observation is that after the large drawdown, the strategy has recovered, as depicted by the upward trending equity line after August.  This is usually the case for short volatility strategies.

Despite the big loss, the overall return (not shown) is still positive. This means that the strategy has a positive expectancy. Drawdown can be minimized by using a correct position size, stop losses, and a good portfolio allocation scheme. Another solution is to construct limited-loss positions using VXX options.