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A Short-term VIX Trading Strategy That Works?

Posted in Size Effect, Volatility Effects

Can you trade on the CBOE Volatility Index (VIX), the “investor fear gauge,” or not? If so, what should you trade and should your trades be short-term or long-term? In their September 2005 paper entitled “VIX Signaled Switching for Style-Differential and Size-Differential Short-term Stock Investing”, Dean Leistikow and Susana Yu test the usefulness of VIX level as a signal for short-term switching between: (1) value and growth stock indexes; and, (2) small-capitalization and large-capitalization stock indexes. They note that “…VIX can be viewed as a market-determined forecast of short-term market volatility that, by construction, has a constant one-month forecast horizon.” They determine signals according to whether VIX is high or low compared to its 75-day moving average. They examine index returns for 1 day and 5 days after a VIX signal. Using data for the VIX and for various Standard & Poor’s and Russell stock indexes from the early 1990s through 2004, they find that:

  • Returns for all indexes tend to fall as VIX increases, with the effect more pronounced when VIX is high. Most growth stock indexes suffer more than value stock indexes as VIX rises.
  • VIX has not been useful as signal for short-term switching between value stock and growth stock indexes.
  • VIX has been useful as a signal for short-term switching between small capitalization and large capitalization stock indexes over the past 10-15 years. A strategy of going long (short) a large-capitalization index and short (long) a small-capitalization index when VIX is above (below) its 75-day moving average by at least 10%-20% generally works.
  • While these conclusions hold for both low-VIX and high-VIX regimes (determined by comparing the 75-day moving average with the average since 1986), trading odds are better during high-VIX regimes.

In summary, VIX signals are useful for short-term switching between small-capitalization and large-capitalization stock indexes, especially when VIX is historically high.

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