If you watch a lot of CNBC or read a fair amount of financial news you will no doubt have heard of the VIX Volatility Index, also known as the ‘fear index’.
What is the Vix Index?
The VIX is actually the ticker symbol for the CBOE (Chicago Board Options Exchange) Market Volatility Index future and it represents the expectation of stock market volatility over the next 30 days using S&P 500 options.
Whenever the stock market goes down the VIX goes up and whenever stocks go up the VIX goes down.
Because it measures expected volatility, the VIX might be a good indicator to use when attempting to time the broader stock market and the next chart shows why:
As you can see, we have two price charts, the VIX Index is on the bottom and the S&P 500 is on the top. You can clearly see the relationship in play where a very high VIX usually coincides with a market bottom in the S&P 500.
So let’s see how this relationship stands up to historical testing.
VIX as a market timing indicator
The VIX index was first introduced in 1986, and historical data can be obtained from the CBOE website.
So before we run the first test let’s first see what the buy and hold return is in the S&P 500 Index from 1986. So as you can see, the nominal annual return is 8.05% with a maximum drawdown of -57%.
*It’s worth mentioning that these are the nominal returns. To get the actual, real-life returns, it is necessary to adjust the data for re-invested dividends as well as for inflation.
Now we know the buy and hold returns, can we improve on them using the VIX as a filter for timing?
So if we look at the charts, a 50 level in the VIX seems like a good figure to use as it corresponds with several market bottoms.
So in this first test, we will buy the S&P 500 only if the VIX Index is above the 50 level. And we are going to sell the S&P 500 whenever the VIX Index moves below 10. And this will be using daily bars.
So, here you can see that the annual return has dropped to 6.13% but the drawdown has also decreased to 42%.
If we look at the trades list you can see that the strategy made three winning trades out of three, picking out the market crash of 1987 and 2008 and the downturn in 2002.
So as we have seen, the VIX is good for picking bottoms but it’s not so good for picking tops.
But maybe it could be useful for timing a portfolio.
In the next test, I use the same portfolio momentum strategy that I used in my previous market timing article.
But this time, we are going to plot a 5-week moving average over the VIX Index and we are only going to add stocks to the portfolio if the moving average of the VIX is below 20. We are going to sell the entire portfolio if the moving average of the VIX moves above 20.
In this way, we might be able to exit our positions and move into cash as volatility is increasing and just before a big market downturn.
Running the momentum system on the S&P 500 universe of stocks without the VIX filter, gives an annual return of 10.15% between 1986 and 2014 with a maximum drawdown of -38%.
Now if we introduce the VIX filter and run the test, the annual return drops to 9.63%, but the drawdown decreases to just 16%, which makes this strategy much better on a risk adjusted basis.
So this strategy got the portfolio out of the market before the 2008 crash and the 1987 crash and you can see this from the relatively smooth equity curve.
Of course, that doesn’t mean it will necessarily get us out of the next crash. But the point remains, high volatility always comes at market troughs.
Buying the market during periods of high volatility is a worthwhile strategy but selling the market during periods of low volatility is not so successful.
Using the VIX to time a portfolio reduces risk and looks to have some merit, but the idea might need some fine-tuning because the portfolio spends a great deal of time on the sidelines.
As stock traders, it’s always worthwhile keeping one eye on the VIX Volatility future.