Implied Volatility Index and related indicators:
How you can use them in trading & risk management (part IV)

Continued from "Implied Volatility Index and related indicators: How you can use them in trading & risk management, part III"

In this newsletter, we will show how our IV Index (IVX) can help in entering a trade, and, more importantly, in closing the stock position. We will carry out limited backtesting on recent data and try to interpret the results. In this investigation, we will consider an IV Index absolute value, its value as a percentage of its 1 year scaled range, IVX to HV ratio and HV absolute value - the indicators described in our previous newsletters.

What are we going to backtest

We are going to consider a question of: "What IVX level (or IVX / HV etc. ) one should look for, to have a guaranteed profit from a stock trade ? ". Well, as our site user, sure you understand that such a question is quite naive, or, at least, irrelevant. It is very hard to build indicators-based mechanical trading system, which would yield you a guaranteed profit. The trading experience, and style are at least (or you may say much more) important as scanning the stock universe by different indicators.
So what do we mean indeed?

We are going to backtest a very simple trading strategy, where you buy (or sell) a stock, and take profit or stop the loss when it reaches a certain level, whichever comes first. The position is closed in a month in any case if neither target profit nor maximum tolerable loss is achieved - this simple example is quite illustrative.

We are stepping back a month and a half, to March 19, 2004 and we will look at all the U.S. optionable stocks with prices in $5 - $25 range - slightly more than a thousand of names. Now, we place a set of targets and stop losses - in the terms of expected return. For example, one strategy is that you take profit when it is higher than 10%, and stop the loss if it is larger than 5% of your initial investment. For simplicity, we will assume that you buy without leverage (from cash account), so have to pay 100% of stock price. Again, we take 100% margin requirement for short selling, to make things simpler. The complete set of strategies we are going to investigate is as follows:

Strategy #1 #2 #3 #4
Target Profit 10% 20% 40% 80%
Max Loss 5% 10% 20% 40%

Later, we�ll consider more elegant variant, when targets are not set arbitrarily, but base on IVX level - running a bit ahead, this helps, indeed.

Backtesting - technical details and a baseline

We apply each of the strategies above to different stock groups, based on certain indicator value, namely IVX, IVX to HV ratio (IVX / HV), IVX as a scaled value in 1 year range (IVX1y ) and HV. For each group we calculate the average return, as a measure of strategy success. These indicators are to be compared across strategies and groups of stocks in order to find "the best" one. We will be talking about "high", "low" and "normal" values of these indicators below, so let�s define what we mean beforehand. The table shows the constants we�ve used in backtesting - some of them are based on common-sense, and some we�ve been discussing in earlier newsletters.

Level / Indicator IVX IVX/HV IVX 1Y HV
Low <=20% <=0.8 <=0.25 <=20%
High >=60% >=1.2 >=0.75 >=60%

The values between High and Low are "normal", and outside the band - "extreme".

Let�s look first what we can achieve for 4 strategies above without using any of those indicators - the reference baseline. The table below shows average profit / loss for the whole universe of 1,000+ names. Both buy and sell opportunities are examined.

Strategy #1 #2 #3 #4
Buy 3.21% 5.59% 5.24% 5.03%
Sell 0.60% -1.32% -1.31% -1.13%

Well, a good piece of evidence that we are in a bull market, right ? Buying an average stock you reach 5.6% monthly profit, while selling of the same would not improve your result much. Keep in mind that the figures above are for reference - there is a large variance behind these average values; you would need to buy an entire market to get rid of this variance. Playing with a couple of stocks might bring fantastic profits of 50% monthly - or incur losses of comparable magnitude.

Backtesting results for simple strategies

For each of the 4 strategies, we show only the indicators, leading to the best result, larger than baseline above. We do not show the complete backtesting results just because this piece of data is too large for the newsletter. This illustrates how the "best" choice of indicator is related with trading style - which is far from a trivial thing.. So, let�s see what we have:

Str #1
Buy: Low IVX / HV (3.97%) or High IVX1y (3.94%)
Sell: Low IVX (2.87%) or High HV (3.23%); selling Extreme IVX or HV works good too

We see, that relative indicators slightly help buying in the bull market, while absolute ones (IVX and HV) help to trade against market. All this under quite cautious strategy, with low target profit and tolerated loss. Quite unusual is that you can sell Extreme IVX or HV - never caring is it high or low - evidence that "extreme" stocks do not follow market closely.

Str #2
Buy: High IVX (7.24%); buying High HV works good too
Sell: Low IVX (4.09%)

Absolute value of IVX helps buying, and especially selling under this more daring strategy. HV goes hand-in-hand with IVX.

Str #3
Buy: High HV (7.27%); High IVX works good too
Sell: Low IVX (4.09%)

Basically, same thing as for Str #2.

Str #4
Buy: High HV (6.91%) or IVX (6.40%)
Sell: Low IVX (4.09%)

Seems this strategy is too bold, while still giving good results.

To sum up, for this particular moment in the market, relative indicators help trend-followers with low targets and risk tolerance; for bolder strategies absolute value of IV Index starts to play a leading role, independently of your direction. Of course, this one-day snapshot does not allow for generalizations - more thorough backtesting is needed for this.

Yet more backtesting: more intelligent exit

IV Index predicts future stock variance (or at least they say so), so let�s try yet another strategy, when target profit and max loss are selected based on IVX. If this works - very good - you do not have to guess on your target / stop levels any more, but you would just calculate them on a sheet of paper. As our hypothetical time frame is 1 month, the expected return standard deviation (STD) for this period is IVX divided by square root of 12 (12 months in a year and IVX is an annualized figure). So, we set a target profit at a one STD level, IVX / sqrt(12), and a stop loss at a half of this value.

The baseline for this strategy (buy or sell an average stock) is as follows:
Buy: 5.14%
Sell: -0.94%

This is comparable with the baseline for the "boldest" strategies (Str #3 and #4) - not bad. Buying High IVX or HV yields average profits of 7.22% and 7.14%, respectively - again, same as for best strategies above. Well, it seems that these Bollinger Bands (price levels calculated basing on IVX or HV) are really good to place targets / stops when you follow market. As for selling, Low IVX stocks yield 1.77% profit instead of loss of about 1%. Good, but considerably worse than fixed target / stop profit level of 4.09%.

To be continued...

As we said, one day snapshot is a one day snapshot - it works now, but would it work in future ? How did it work in the past, under different market conditions ? Is there any better combination of indicators to catch the profit? We�ll be returning to these interesting questions in coming newsletters, stay online!