Volatility Trading Strategies – Trade And Make Money In Volatile Markets (Backtest)

Last Updated on June 19, 2022 by Quantified Trading

This article discusses different aspects of volatility trading strategies. Why volatility? 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. Thus, it might pay off to trade during panics, stress, and volatility. It might be scary, but it’s normally during these times you can make decent profits.

Volatility trading strategies can be very profitable. As an example, we show you an equity curve that only trades when volatility is above what is “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 SP 500 is below its 200-day moving average. When volatility picks up, even short trades become very profitable!

(We have made potential trading strategies based on volatility. Please check out our strategy bundles.)

Before we discuss our S&P 500 trading strategy, we share some words on when you are likely to see a volatile market:

Volatility is (mostly) synonymous with bear markets

A few weeks back we published an article about the bear market of 2000-2003:

A trader should love a bear market for apparent reasons: volatility picks up and long-only strategies improve. Even better, short strategies become profitable! Short strategies in stocks are very rare because of the tailwind from the overnight bias: most of the gains in the stock market have come from the close until the next open.

What is the best way to trade volatility?

There is, of course, no best or worst way to trade volatility. A dollar profit in strategy A is just as valuable as a dollar profit in strategy B. However, volatility strategies perform better in certain market conditions. One of the better filters for that is the 200-day moving average. Let’s look at how S&P 500 behaves when it’s above and below the 200-day moving average:

When do we get volatile markets?

Because volatile markets happen mostly in bear markets, 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. Bear markets are good for traders! Even better, even short strategies normally work much better the more volatility there is.

The 200-day moving average and its significance for separating volatile 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:

Volatility during bear and bull markets

In a bear market, volatility “always” picks up. And, perhaps, contrary to what many believe, trading from the long side tends to improve when the market is falling.

Let’s look at volatility data in the S&P500. 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
Below Above Below Above Below Above Below Above
1.57 1.1 1.66 1.06 1.88 1.02 2.09 1.05

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. In a previous article about the anatomy of a bear market we gathered some stats about bear markets.

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:

An S&P 500 trading strategy with volatility (volatility index trading strategies)

Which strategy can you use for volatility play?

Below we share one example, (more strategies coming later in this article) even though we don’t reveal the code. We have plenty of free strategies on the website, and short strategies are hard to come by, at least in the stock market, and thus we want to save it for our paying customers.

Below we have an equity chart that only takes trades when the close yesterday was below its 200-day average (plus two additional criteria):

S&P 500 Trading StrategThe equity chart includes both long and short trades and has the following data:

S&P 500 Trading system

The S&P 500 Trading 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 SP 500 Trading 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:

S&P 500 Trading Strategy With VolatilityThe number of trades increases from 224 to 716, while the CAGR drops to only 3% despite being invested 16% of the time. The average gain goes down from 0.7% to a tiny 0.12%.

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.

How to trade volatility?

The volatility trading strategy above was just an example, and a moving average is, of course, not a necessity.

You can trade volatility either by using certain indicators or parameters for stocks and indices (or whatever asset you are trading), or you can also trade volatility itself, for example, VIX futures (more below on VIX). Among our free trading strategies you can find many strategies that are more or less based on an increase in volatility.

Using implied volatility to forecast stock prices

Implied volatility is the expected future volatility priced into the options market. The two most important factors in the option price are volatility and the price of the asset (out of the money, at the money, or in the money). The more volatile an asset is, the more expensive the option. That makes sense. Think of an option as insurance and you probably understand why it makes sense to require more for a contract that is volatile compared to one that is not volatile.

Is implied volatility good at forecasting future volatility?

Most of the research we have studied concludes that implied volatility is better at forecasting future volatility than the past realized (historical) volatility of an asset. We are not going to delve into this but we mention it so that you are aware of the theory and practice.

Historical volatility

Historical volatility differs from implied volatility. Implied volatility is an estimation of future volatility, while historical volatility is what the volatility has been over the last x days. Historical volatility is a fact. We believe it’s safe to say that historical volatility is a reasonably good estimation of future volatility if you use a long lookback period, for example, 100 days or more.

How is historical volatility calculated? Volatility tends to be like ebb and flow, but over long periods it moves slowly, and we can use many different indicators to calculate historical volatility:

Historical volatility

The chart above has three different timer periods for the ATR indicator: 15, 150, and 200 days. Volatility has picked up lately, as is pretty evident from the three different ATRs.

Another measure of volatility is Bollinger Bands. The bands are based on a moving average and have two bands above and below that are x standard deviations away from the moving average. When volatility is low, the bands are “tight” and close to the average. When the price moves, the bands expand and get wider. This is an easy method to see how historical volatility has changed over time.

Volatility indicators

Does it exist an indicator to measure volatility? Yes, the most used is the VIX. VIX is, by far, the most famous volatility indicator:

The VIX indicator

VIX measures the fear in the market. How does it do that?

It measures fear by calculating the implied volatility in the near-term expiration of the S&P 500 options contracts. Thus, the implied calculation is a forecast of the market’s aggregate expectations of the volatility in the coming few weeks. The more fearful investors and traders are, the more they are willing to pay for the cost of insurance (options). This is why it’s called the fear index. Uncertainty is the enemy for most investors and traders, both in the market and in everyday life, and this is why we are willing to pay for reducing uncertainty. Remember the saying: A bird in the hand is worth two in the bush.

VIX has the ticker symbol VIX and can be downloaded as ^VIX at Yahoo!finance (for example). You can track it in real-time throughout the trading day, and it’s even traded as a futures contract at the CBOE from 2004 and options contracts from 2006. Even a mini-contract (VME) can be found.

VIX is, in short, the sum of the market’s future expectations of market volatility. VIX can even be used as an intraday volatility indicator, although we have not found it useful on very short-term time frames.

It’s a mean revertive indicator as can be seen in this graph:

We have written a separate article about VIX called 4 VIX trading strategies that goes more into depth about VIX.

The VXN indicator

For Nasdaq 100 you can find a similar contract as the VIX: VXN. It’s practically the same as VIX, but obviously tracks the Nasdaq 100 instead of the S&P 500.

WilliamsVixFix indicator

The famous trader Larry Williams created a “synthetic” VIX in 2007 for assets or instruments that don’t have a VIX or option contracts to measure implied volatility.

How did Larry Williams create the VixFix? He did the following:

  1. Find the highest close over the last 22 days and subtract the low of today (or the current bar).
  2. Divide by the highest close of the past 22 days.
  3. The result is multiplied by 100 to “normalize” the indicator.

22 days was chosen because that is a typical length of a trading month. We are not going into more details about WilliamsVixFix, but you can read more in our separate article about WilliamsVixFix indicator and strategies.

ATR indicator

Another indicator that is based on volatility is the ATR indicator. The indicator is based on three different calculations, and it expands as volatility picks up. Risk management frequently involves adjusting for volatility, and ATR is very often used for volatility position sizing.

What is the best volatility indicator?

The answer is pretty simple: there is no best or worst in trading. If you have a strategy that works, that’s fine. If it doesn’t work, then skip it. Keep in mind that all asset classes behave differently. Volatility trading strategies for crypto, might not work on stocks, for example. Likewise, option volatility trading strategies are based on other parameters and logic than stocks and commodities.

 

Volatility trading for beginnersvolatility trading strategy

We have put together 3 volatility strategies (strategy bundle or pack) that contain different logic and strategies for S&P 500 (SPY or @ES). We trade at least one of the strategies ourselves and they give you an idea of how you can go about making trading strategies.

Is trading volatility profitable? Conclusion

At the end of the day, every trader needs prey to make money. Prey in the market equals movement and volatility. High volatility can be both scary and uncomfortable, but the truth is that the best traders make the most money when volatility picks up. For example, our own records show that we had our best year in 2008 when markets plunged. Furthermore, we made most of the money on long positions – not short.

Volatility trading strategies are thus a craft you need to master. 

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