Last Updated on July 6, 2021 by Oddmund Groette
In order to make money trading, you need prey. One of the prerequisites for trading is volatility. No volatility, no prey. No prey, no gains.
In this article, we do some statistics on volatility and backtest one strategy that only generates signals when the volatility is higher than “normal”.
We use a 200-day moving average as a filter for when we want to enter a trade. Because the volatility picks up when investors are “panicking”, we only look at trades when the S&P 500 are below its 200-day moving average. When volatility picks up, even short trades become very profitable!
Bear markets create prey, volatility, and opportunities
A few weeks back we published an article about the bear market of 2000-2003:
For apparent reasons, a trader should love a bear market: volatility picks up and long-only strategies improve. Even better, short strategies become profitable!
What is a bear market?
In this article, we use a very simple method to separate bear and bull markets: if the close is above an x-day moving average, it’s a bull market. If the close or price is below the moving average, it’s a bear market.
The 200-day moving average and its significance for separating bear and bull markets:
One of the most widely used moving averages is the 200-day average. The famous Paul Tudor Jones once said this about the 200-day moving average
My metric for everything I look at is the 200-day moving average of closing prices. I’ve seen too many things go to zero, stocks and commodities. The whole trick in investing is: “How do I keep from losing everything?” If you use the 200-day moving average rule, then you get out. You play defense, and you get out.
Is it any truth in this? As it turns out, it is:
But should traders worry about a bear market? No, quite the opposite:
Bear markets are good for traders
Bear markets are good for traders because volatility picks up a lot.
Furthermore, even short strategies normally work much better the more volatility there is.
To give you an example we recommend you to read the above article we linked to about the anatomy of a bear market.
In the article, we referred to a certain strategy that improved its performance during a bear market even though it’s a long-only strategy. Both during the bear markets of 2000-2003, 2008-2009, and the covid mess in March 2020 the strategy generated significantly better averages than during a bull market.
Volatility during bear and bull markets:
Let’s look at volatility data in the S&P 500. We use the ETF with the ticker code SPY as a proxy for the S&P 500:
Below is a table showing the daily percentage difference between high and low (compared to the closing price) when the close for the day is below or over the x-day average from 1993 until June 2021:
|5-day average||5-day average||10-day average||10-day average||50-day average||50-day average||200-day average||200-day average|
If the close is below the 200-day moving average, the average daily movement is 2.09%. If the S&P 500 is above the 200-day moving average, the average daily movement is only 1.05%. Quite a difference!
Typically, the VIX picks up when we have a bear market. The premium for insurance gets higher, something many are willing to pay for.
Can we take advantage of the increased volatility when the S&P 500 is for example under its moving average?
It turns out we can:
A volatility trading strategy in the S&P 500
Below we have an equity chart that only takes trades when the close yesterday was below its 200-day average (plus two additional criteria):
The strategy’s three criteria for long and short are exactly the same except they are opposite (of course). About 45% of the trades are day trades, ie. both the entry and the exit are on the same day.
This strategy generates 5.6% annual returns (0.7% per trade) while only being invested in the market a tiny 4.6% of the time. We think these are pretty impressive numbers (?).
The strategy only enters into trades when the previous day had a close under the 200-day moving average. What happens if we flip it and only enter when the close is above the average? We get this equity curve:
We believe the above strategy is so promising that we’ll later include both the long and short criteria as one monthly Trading Edge, thus we prefer to disclose it only to our loyal subscribers.
Disclosure: We are not financial advisors. Please do your own due diligence and investment research or consult a financial professional. All articles are our opinions – they are not suggestions to buy or sell any securities.