Last Updated on September 12, 2022
The VIX and VXO are frequently used to time entry and exits in the S&P 500 and Nasdaq. In this article, we present you with a trading strategy that has beaten the S&P 500 despite being invested only 22% of the time.
In this article, we present you with a chart that has proven to beat the market since 1986 – solely by using one simple criterion/indicator (VXO). VXO is an index that measures the implied volatility of the S&P 100.
(VXO has since stopped trading since the article was published, unfortunately.)
VIX vs. VXO: What is the difference?
The volatility indices are traded and calculated on the CBOE.
The VIX indicator, the most famous volatility index, was first based on the S&P 100. But in 2003 the CBOE decided to base the VIX on the volatility of the S&P 500 index, and the VXO was created to measure the S&P 100 volatility.
Still though, the VXO is still widely used and has a history back to 1986.
Are VIX and VXO different? Both the VIX and VXO is displayed in the chart below (VIX upper pane):
As you can see, they both move more or less in tandem but varies slightly in velocity and percentage movements.
Thus, we can expect to get slightly different results if we test by using the same parameters.
The main principle of volatility trading is that increased risk increases future expected returns
The main idea behind most volatility indices is to reap higher returns when the volatility picks up. Why is that?
That is because prices go down when the risk increases. When the risk is increasing, investors demand higher expected returns to accept that increased risk. This is “solved” by falling prices.
Hence, when the risk goes up you can expect a higher return going forward. However, nothing is certain, as the risk can continue going up and thus lower prices.
A VXO trading strategy
Below is a trading strategy that is beaten the S&P 500 since 1986. The backtest is from 1986 until today because we were not able to get VXO data before that.
Below is an equity chart that shows a very simple VXO strategy that has beaten buying and holding the S&P 500 since 1986:
We would argue this is a pretty good and solid strategy based on the equity curve (what is a good equity curve?), yet very simple with only one parameter. It’s a weekly strategy and trades at the close on Fridays, thus the trading strategy is easy to implement.
The lower pane shows the trading drawdowns from the last top in equity. The CAGR (what is CAGR?) is 9.25% vs buy and hold of 8.8%. However, the strategy is only invested 22% of the time and the max drawdown was 31% in 2008, substantially lower than S&P 500s 55%. The risk-adjusted returns are 24% (please read more about trading risk parameters).
The number of trades is 494 which equals about 14 trades per year. As mentiones, because this is a weekly strategy, buying and selling is done at the close each Friday.
The VXO trading strategy has only had two down years:
The reason for the underperformance is simple: It’s because the S&P 500 has only gone one way, and that is up. A strategy that only spends a limited time invested will not manage to keep up with the averages under such investment climates.
VXO trading strategy – ending remarks
We believe our VXO trading strategy is a great example of how you can make a good yet simple strategy with excellent risk-adjusted returns. Less is more in trading!