Trading Volatility to Hedge Equity

November 28, 2019
Posted in Money Talks
November 28, 2019 admin

The term volatility trading is usually reserved for options trading, options have volatility as a major component of the price model so every options trader must know the volatility of the traded underlying in order to be consistently profitable. Volatility is not a natural part of equities trading as most equity traders are trading the underlying without looking at the derivatives (such as volatility), in this article we will test a strategy that is based on equities plus a volatility component that is represented by a volatility ETF (VXZ in this case, which is the midterm VIX futures exposure, more details here), we will try and exploit the explosive nature of the volatility ETF to compensate for short down moves in the market, thus the general idea is to trade the market as long as its trending up but open long positions on the volatility ETF as the market moves down so the overall performance is much better than just buying the market and holding it through volatile time periods.


QQQ vs VXZ

In the chart above you see the performance of the Nasdaq100 index represented by the QQQ ETF, and the performance of the volatility index as VXZ ETF. Every time the market dropped you can see the mirror reaction of the volatility index, once the market moved up again, the volatility index returned to its normal course. This is exactly what I would like to use in this strategy, once the market drops the strategy will use the fast reaction to offset the market drop waiting for the market to return to its natural bias to the upside.

This way we use volatility as a hedging strategy protecting the trader from rapid downswings.

The core indicator used by the strategy is Bollinger Bands %B which measures the price location with relation to a volatility band (more on the indicator here), this way we, again, use volatility to our advantage this time using the Bollinger Bands which stretches around the price with standard deviation bands, the %B indicator is a powerful indicator to measure price stretching points.
In addition to the volatility aspect, the values for the %B indicator are normalized regardless of the price absolute values, providing a standard way to test the price action against an absolute value, more on that issue in the next section.

The strategy is tested on the two ETFs above , over the course of 2009-2019 with these rules:

  1. Open long position in case the Bollinger Bands %B crosses up the 0.45 level 
  2. Close the position in case the Bollinger Bands %B crosses down the 0.55 level

Performance:

Total Return: 264.23%
Sharpe: 2.11
CAGR: 12.93%
Max Drawdown: -4.40%


Now we add the short side of the trade,adding these strategy rules:

  1. Open short position in case the Bollinger Bands %B crosses down the 0.55 level
  2. Close the position in case the Bollinger Bands %B crosses up the 0.45 level 

Performance:

Total Return: 349.7%
Sharpe: 2.06
CAGR: 14.98%
Max Drawdown: -7.23%


In both cases, the strategy produced a positive return in
all years traded (and about 85% of months traded displayed positive returns), comparing the volatility hedging strategy to the NASDAQ100 drawdown is displayed in the graph below:


Volatility Hedging Vs NASDAQ100 Drawdown comparison

So to conclude, despite the fact that volatility is reserved for the options traders, equity traders may benefit from trading volatility by long and short positions on the volatility ETFs combined with an index ETF, volatility bursts may compensate for the short time periods of drawdown in the index performance and increase consistency in returns,

For the strategy code (Python code using backtrader as backtesting platform) and the secret sauce of position management, contact us at info@alphaoverbeta.net

As always, trade safely,
Alon 

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