VIX, Technical Analysis Combo Advanced

Model Description

Overview and Implementation

For maximum responsiveness with 23/5 trading, this model exclusively trades the S&P 500 Futures Contract. However, it can be implemented fairly accurately through any ETF or other instrument that tracks the S&P 500 such as SPY or VOO. The model is always either 100% long SPX or 100% cash. Each trade alternates between these two positions. In practice, many investors implement our models through a hedging system instead. For example, on a buy signal, you would hold your regular diversified portfolio of ETFs and stocks as you do now. During a sell signal, you would sell S&P 500 Futures contracts against the value of your holdings for a net market neutral overall position. This method has the added benefit of lower overall tax liability.

Trade Frequency

VIX-TA Advanced is an average frequency trading model with 182 total trades over the 15.00 year period. On average, the model made one trade per 20.77 trading days. However, the trades are not uniformly distributed; during periods of higher market volatility, more trades were made compared to relatively calm periods.

VIX-TA Advanced is best for medium/long term investors and swing traders who want to both avoid large drawdowns and substantially outperform the benchmark. At 63.74% trade win rate, traders following this model will occasionally run into false positives. Think of these as insurance premiums that are well worth paying to avoid the potentially massive drawdowns that are bound to happen from time to time (such as the -36.01% thrashing the SPX took during the COVID-19 crisis).

Compared to our VIX Advanced model, VIX-TA Advanced makes fewer overall trades while substantially improving both CAGR and max drawdown.

Key Indicators

This model focuses on both the Cboe Volatility Index (VIX), an index that represents the market's expectations for the relative strength of near-term price changes of the S&P 500 index (SPX), and several TA indicators.

Indicator Overview

A few of the indicators this model uses behind the scenes are:

1. Absolute VIX level
2. VIX futures curve shape (degree of backwardation vs contango)
3. Realized volatility vs implied volatility trend
4. VIX sensitivity
5. Derivative analysis of change in VIX futures structure
6. Bollinger Bands
7. Chande Momentum Oscillator (CMO)

The model uses these and other minor indicators under varying and adaptive time parameters to identify medium-term trend changes. As with all our models, we run the backtest through our proprietary anti-overfitting machine learning system to ensure we are identifying real and repeatable patterns.

VIX-TA Advanced is not merely a combination of our VIX Advanced model with our other TA models. Even though it uses many of the same core indicators, it is much more sophisticated in how it applies them in decision-making. This sophistication leads to substantially better performance on both an absolute and risk-adjusted basis.

Indicator Analysis

Many savvy traders have been using the VIX to their advantage in identifying local minima and maxima on the daily or weekly charts for a long time. VIX-TA Advanced uses several derivative analyses of underlying VIX movement. Some examples:

• SPX and VIX divergence. Most of the time VIX and SPX are inversely correlated. The rare times when they are not (i.e. both SPX and VIX increasing or both decreasing), is a tip to our model that we may be near a trend shift.
• VIX sensitivity to movements in the SPX. Usually the VIX moves inversely to the SPX with a sort of beta multiple of around 3-5. i.e. if the SPX is down 1% for the day, VIX will usually be up 3-5%. When the VIX responds well outside that normal range (i.e. VIX up 10%+ or flat), that's a sign of a potential trend reversal on the horizon.
• Shape of the VIX futures curve. Traders of VIX futures are well-known to be very sophisticated market makers and institutional investors that are making intelligent plays over the long run. 85% of the time, the VIX futures curve is in contango which means that longer dated contracts are priced higher than nearer dated contracts. This make sense intuitively as just like option premium, the longer the time between now and expiration, the greater risk of some disaster upending the system. 15% of the time, the VIX futures curve falls into backwardation. This is when nearer dated contracts are priced higher than longer dated contracts. This signals to the model that a near-term bottom is likely imminent, as sophisticated traders believe that the current risk event does not have lasting power.

Technical analysis (TA) is a trading discipline used to identify trading opportunities by analyzing statistical trends gathered from trading activity, such as price movement and volume. In aggregate, TA is about analyzing the psychology of market participants through their transactions. Some examples of TA used in this model:

• Bollinger Bands with RSI and SMA synchronicity on multiple time frames. Bollinger Bands (BB) draw two lines around a simple moving average (SMA) based on a positive and negative standard deviation. During times of volatility, the bands widen and then contract when volatility subsides. When price moves well outside the bands in either direction, it can be a a warning sign that the price action has been unsustainable and that price is likely to mean-revert back inside the bands soon. Combining these extreme movements with the relative strength index (RSI) as well as where the current price rests in relation to important SMAs (such as 20 day, 50 day and 200 day) can be a tip to the model that we are likely near a local minima or maxima.
• Chande Momentum Oscillator (CMO) uses momentum to identify relative strength or weakness, classifying such periods by degree of overbought / oversold. By itself, CMO usually does not generate fantastic signals, but when combined with RSI, SMA, BB width and other TA indicators and analyzed across multiple time frames for synchronicity, it can be a valuable tool in guiding the model to certain signals.

When building the model, we took these and many others into consideration and carefully tested the patterns using machine learning and heuristics to distinguish those with predictive power against those that merely seemed like they had predictive power. This is what we call our proprietary anti-overfitting engine, and although no model can ever perfectly predict market movements, with this engine you can rest easy knowing the model is backed by the latest science and engineering. We leave human emotion at the door; the signals are generated 100% mechanically.

Performance

VIX-TA Advanced achieved an annual CAGR of 30.78% vs. 12.66% for SPX which we use as the benchmark. This represents a substantial outperformance of 18.12% per year. $100,000 invested in the model at inception would have grown to $4,374,310. Following the rules of all investment professionals, we must of course disclaim that past performance does not guarantee similar results in the future. However, our testing period covers many different market conditions, from the uber turbulent COVID-19 drawdown in Feb-Mar 2020 to the incredibly complacent 2013 and 2017 years. This lengthy period of analysis, combined with our proprietary anti-overfitting system, gives us confidence that our model has alpha.

Drawdown

Historically, the model had a maximum drawdown of -22.96% vs -36.01% for the SPX. This represents a substantial reduction in drawdown vs. the benchmark of 36.24%. When looking for a great model or market timing system, it's very important to not only consider absolute performance but also drawdown because investors should value risk-adjusted returns above absolute. The model's combination of absolute outperformance and smaller drawdown is exactly what savvy investors should be looking for in an actionable market timing system.

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