Master Volatility Futures: VIX Trading Strategies 📉

VIX📉 The Fear Gauge!

Imagine having a crystal ball that predicts market direction with impressive accuracy! Sounds like a dream, right? Well, that's the power of the Volatility Index, or the VIX, often dubbed the "fear gauge" of the financial markets.

If you're a trader or an investor, understanding the VIX can be a game-changer. The VIX represents the market's volatility expectations over the next 30 days for the S&P 500 Index.

The VIX, like all instruments in the financial markets, follows patterns. Recognizing and understanding these patterns can provide traders with a significant edge.

In this post, we're going to uncover the VIX's seasonal behavior and explore actionable strategies for trading the VIX effectively.

 1) The fundamentals of the VIX and its relationship with the S&P 500

• Calculation: The VIX is calculated using a wide range of S&P 500 Index options, both calls and puts. The methodology captures the market's expectations of future volatility based on the premiums investors are willing to pay for these options.

• Interpreting the VIX: A VIX value above 20 is generally considered high, indicating significant fear or uncertainty in the market. Values below 20 suggest a more stable and less volatile market environment. Essentially, when the VIX reading is low, it signals that everything is normal in the market, usually leading to a grinding uptrend in the S&P 500 Index and its components. Conversely, when the VIX spikes, it indicates fear and uncertainty, often coinciding with a sharp downturn in the S&P 500.

• The VIX and the S&P 500 Index relationship: When the VIX spikes, it typically signals a drop in the S&P 500, and when the VIX declines, it often indicates a rise in the S&P 500. This relationship is pivotal for traders, as it allows them to use the VIX as a predictive tool for market movements. Most traders think of this correlation as a fixed number, but in fact, it is a dynamic relation that changes over time.

Below is the daily correlation chart between the VIX & SPX

The blue line shows the continuous correlation between SPX & VIX. We notice that the line spend most of its time under -0.5 which is a clear negative correlation on daily and weekly timeframe.

Below is the weekly correlation chart:

"The Vix moves in the opposite direction of the S&P500, a key relationship to understand."

2) Historical patterns and seasonal trends in the VIX

Historical data reveals that the VIX tends to follow a specific seasonal trajectory. Data from the past 34 years shows a consistent decline in the VIX from mid-March until mid-July, followed by a rise until mid-October, and then another decline.

Below is a chart by Seasonax showing the patterns:

These patterns can be traded using options. They can also be used as filters for other strategy signals.

If you'd like to discover more high-probability seasonal trading opportunities like the one above, check out Seasonax. This powerful tool lets you filter thousands of patterns with just two clicks, optimizing your trade timing with up to 95% accuracy. Whether navigating a financial event or fine-tuning your entry points, Seasonax’s proprietary algorithms and extensive historical data put the odds in your favor. Start leveraging the benefits of seasonal patterns today.

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Explore Seasonax for free, and if you decide to subscribe, use this link for a 20% discount and elevate your trading strategies now!

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3) Short-term trading strategies for the VIX

Long-term strategies, such as seasonal patterns, can be highly effective but often require holding positions for several months. Short-term strategies, on the other hand, allow traders to capitalize on more immediate market movements, providing flexibility and the potential for more frequent gains.

Due to the strong negative correlation between the SPX and the VIX that we discussed earlier, many strategies that are effective for the SPX are likely to work inversely for the VIX.

I mentioned this many times on StatOasis YouTube channel, the SPX tends to perform well with long mean reversion strategies. I'll explain how to identify these edges in another post. Given this, we can infer that the VIX is well-suited for short-mean reversion strategies. To verify our thesis, let's explore 3 simple short mean reversion strategies:

Strategy 1: Highest High of the past 5 days

Short Entry: High = Highest (High,5)

Short Exit: RSI(C,2) < 25 or Fixed 10 Bars

Below are the metrics for the basic strategy 1

Also the equity curve for strategy 1, and it shows the power of identifying market edge, as you don't need complicated methods to find a good start to build a strategy.

Strategy 2: Consecutive Higher Closes

Short Entry: C > C[1] > C[2] > C[3]

Short Exit: RSI(C,2) < 25 or Fixed 10 Bars

Below are the metrics for the basic strategy 2

Below is the equity curve for Strategy 2. Much more promising as shown by the low drawdown and the drift-up.

Strategy 3: RSI2 Overbought

Short Entry: RSI(C,2) > 75

Short Exit: RSI(C,2) < 25 or Fixed 10 Bars

Below are the metrics for the basic strategy 3

Below is the equity curve for strategy 3. Not surprisingly, the strategy shows a big drawdown similar to the first strategy, as both have a very similar logic.

4) Building a portfolio of uncorrelated strategies

While the short-term strategies discussed earlier can be effective on their own, adding filters can significantly enhance their performance. In this section, we will explore the role of filters in refining VIX trading strategies and provide examples of how they can be applied.

Filters are additional criteria that must be met before a trade is executed. They help to eliminate less probable trades and focus on higher-quality setups. By incorporating filters, traders can:

• Reduce Noise: Minimize the impact of market noise and erratic price movements.

• Increase Accuracy: Improve the accuracy of trade signals, leading to better overall performance.

• Enhance Risk Management: Control and manage risk more effectively by avoiding low-probability trades.

To illustrate this, I combined the three basic strategies above, each with a different filter, applied to the same historical data, targeting lower correlations.

Below are the results:

The Portfolio had a 42% exposure with 73.5% win rate and a whopping $1,378 average trade.

👉Action Steps⚡

Long Term Patterns:

• Use platforms like Seasonax to analyze historical patterns of the VIX.

• For the Long Term Pattern identified in Seasonax (mid July to mid October), use Call Options.

• Choose a strike price that is slightly out-of-the-money (OTM) to benefit from the leverage. OTM options are cheaper but can provide substantial returns if the VIX rises as expected.

• Select an expiration date that aligns with the anticipated period of increased volatility, typically mid-October. This allows enough time for the trade to develop and for the VIX to rise.

Short Term Patterns:

• Apply a mean reversion strategies for short-term trades.

• Utilize futures for leveraged trading.

• Use the same exit for all strategies for simplicity, a 10-bar exit or when the RSI goes below 25.

• Add filters to your strategies to improve return-to-drawdown ratios.

• Mix filters for different strategies that give a smoother equity curve.

• Monitor correlations between strategies to reduce risk.
  
  

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