Protecting High Yield Bond Investments with VIX/VXV Based Timing


Monday, November 12th, 2012 | Vance Harwood

The holy grail of investing is a market timing method that gets you out of the market on bad days and gets you in for the good days.   There are innumerable methods for doing this, ranging from slogans, “Sell in May and Go Away” to closely guarded multi-factor proprietary algorithms.

The worst methods have no apparent causal relationship between the predictor and the thing being predicted.  A non-stock market example is the “Redskins Rule.”  Between 1940 and 2008 if the Redskins won the Sunday before the election the party that won the popular vote in the prior election won the presidency—17 out of 18 times.  After Obama’s re-election this rule is now 17 of 19.  These non-causal rules are just coincidence, if you look at enough data you will find them everywhere—and they mean nothing.

Most stock market timing methods are based on price action—things like moving averages, technical chart indicators, price/earnings ratios, or pattern recognition.   At least they have some sort of connection to the stock market.

Recently I’ve been looking at volatility metrics for predicting market action.   The CBOE’s VIX index gets a lot of attention, but using absolute values of the VIX to trigger investments is almost certainly useless.  On the other hand, volatility prices over different time frames, often called the term structure, does show significant predictive value.

In a truly bearish market the short term expected volatility, typically cheaper than longer term volatility, climbs higher than the longer term value. This behavior is shared between flavors of VIX (e.g., the one month VIX & its three month version VXV), VIX futures, and the implied volatility of same strike options of different months. The chart below from VIX Central shows the progression in VIX futures prices from before the May 6, 2012 Flash Crash through the 7th.

VIX Futures Term Structure May 2010 (VIXcentral.com)

 

A simple metric that captures this behavior divides the short term volatility number by a longer term number.  If the ratio is below one the market is relatively calm, if above one the market is especially nervous.  I’ve been using the CBOE’s VIX & VXV indexes as a convenient way to implement this volatility metric.

I’ve been running simulations using the VIX/VXV ratio as the entry / exit trigger point for market positions.  The chart below shows the price performance of the speculative bond fund JNK, since its inception in 2008 compared with SPY, which tracks the S&P 500.



JNK’s performance would be disappointing if it wasn’t for its high dividend payouts, averaging 10% (!)  per year.  This next chart shows JNK’s performance if you had closed your JNK position whenever the VIX/VXV ratio at market close was greater than 0.917, re-entering when the ratio at close was below that level.


This strategy would have enabled you to avoid the entire 2008/2009 meltdown, plus adding about 3% of extra performance in 2010 through 2012.

Why 0.917?   There’s nothing magical about it.  It was just the best compromise choice over the last three years.  The chart below shows the performance for JNK for all realized VIX/VXV levels for 2010, 2011, and 2012.


In my simulations this threshold worked well for high yield bond funds (JNK, HYG), high dividend funds (SDY), inverse volatility (ZIV, XIV) and general equity (SPY).

Eventually, perhaps tomorrow, this heuristic will stop working, but for the time being it’s a good tell for the market.

 



Monday, November 12th, 2012 | Vance Harwood
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  • http://seekingalpha.com/user/70713/instablog Marc Jolicoeur @ContangoMojo

    Vance,

    Many people quote and track put/call ratios as timing signals. They are just another heuristic to measure the amount of hedging and fear in the S&P options.

    Have you tried to see if VIX/VXV is superior to, or can be confirmed by put/call ratios?

    I have been using the VIX/VXV ratio daily for over a year. When you plot the ratio over years of data you can see clear waves of complacency and fear.  It works as an oscilator too, showing us good reversals at the extremes.  This is a useful indicator for a long term investor that wants to make minimal trades.

    The trigger value 0.917 is curve fitting but even if an investor used pretty much any value between 0.9 and 1.0, this would help them avoid the nastiest of bear market corrections. 

  • vance3h

    Hi Marc, I’ve never been a put/call ratio fan, at least if they are just tracking volume/open interest because you and I know that calls can be used for bearish strategies as well as bullish. So, no I haven’t compared. I suspect a version of the ratio based on VIX futures would be better. but it would have to be adjusted for constant maturity, which would require some daily work.

    I agree that anything between .9 and 1 is a decent threshold.

    – Vance

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  • Skcary

    I am a little confused regarding the last chart. Is it saying that in 2011, if you sold JNK every time the VIX/VXV level got to say, 0.95 (or anywhere between 0.92-0.98 for that matter), that you would have actually lost money, not gained?

    If I am reading the chart correctly it looks like there is a large amount of variation in how performance changes based on both the ratio you sell at and the calendar year. 2011 just looks so much different than the others it is hard for me to see a real trend that says a higher ratio is more bearish.

  • vance3h

    Hi, Yes in 2011 ratios in that range caused losses–because they didn’t get you out before the drops, and kept you out during the rebounds. This chart shows .95 vs just holding JNK. The green line is the number of shares held. http://sixfigureinvesting.com/wp-content/uploads/2012/11/JNK.95.jpg I didn’t include 2009 for clarity, but it shows a similar drop off in performance in the .95 to .975 range.

    – Vance

  • Ed

    Do you know what ratio would have worked in 2011?

  • http://www.sixfigureinvesting.com/blog Vance Harwood

    Hi Ed, If you look at the 4th chart you will see the results for 2011. It looks like anything higher than .92 was iffy. There was a peak around a ratio of 1.0, but I would avoid that area because the market is pretty nervous at that point.

    Best Regards,

    Vance

  • Ed

    Thanks Vance: In chart three it sort of looks like the ratio did tend to work in 2011. Without having the ratios in chart 3, I have difficulty in comparing the charts.

  • Ping

    The VIX/VXV ratio was .92 yesterday (1/23/14). Last night, I couldn’t sleep and placed market-on-open sell orders for most of my positions. I am glad I did. Today, the VIX/VXV ratio ended at 1.04 and VIX jumped 32%. I learn a lot from your volatility articles. Thank you!

    I am just curious. What would you invest in now or in the near future?

  • http://www.sixfigureinvesting.com/blog Vance Harwood

    Hi Ping, Glad it worked out for you. The ratio threshold usually doesn’t work as well as it did yesterday, but I think it is better than just the absolute level of the VIX as an indicator of market nervousness.

    Regarding investments, I’m guessing the S&P will have a good year, maybe up 12%. Macro economic stuff looks solid and I don’t see any worrisome bubbles yet (e.g, a la tech bubble, or housing bubble). I expect long term interest rates to increase so I’m staying away from longer duration bonds. I still plan to be short volatility (e.g., with ZIV) quite a bit, but I do expect the year to be more volatile than 2012/2013 so I’ll be careful. I’m currently investing some in VelocityShares’ SPXH using 5% OTM puts as an additional hedge. It offers full exposure to the S&P with some protection on the downside.

    – Vance

  • Peter

    Thanks for sharing your work. I’m a big fan of trading the volatility ETF / ETNs and always looking for better tools.

    I was charting ZIV and XIV using the VIX/VXV ratio with a .91 trigger and noticed the ratio triggers nearly identically to the VIX crossing 15.29 and VXV crossing 16.34.