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

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

In our previous newsletters, we've compared different IV Index based indicators as to how they help a stock trader. The strategy that was buying high IV Index (IVX) stocks and selling low ones seems to be working - at least in recent times. Now, we are going to check the results of such a strategy in a bit wider historical range.

Misprints in the previous newsletter

First, we have to apologize for a couple of annoying misprints in our previous newsletter. You might wish to review the fixed version here . The misprints are:

  • March 19, 2004 was a backtesting date, not April 19.
  • in the third table, the monthly return of 0.60 % should stand instead of 5.03 % for most cautious Sell strategy - quite a difference in frames of our investigation.
  • an important comment in the beginning of "Backtesting results for simple strategies" section was simply left out, just after Str #1 results.

Trading strategy

We are going to use the strategy with the exit rule depending on IVX value - exactly the same as used in last chapter of the previous newsletter. All the assumptions from Part 4 are held: only stocks between $5-25 are considered, you have to pay 100 % if buying the stock and there is 100 % margin requirement for selling. The rules of exit for both Buy and Sell strategies are:

  • Take profit if return is equal to or greater than 1 standard deviation (STD)
  • Stop loss if return is equal to or less than -0.5 standard deviation
  • Exit after 1 month passed if none of the above occurs

If you feel uncomfortable with standard deviation, let's remind that it is quite a simple thing - just IV Index divided by square root of number of months (=12) in our case, as we are holding 1 month trading horizon. For example, if stock IV Index is 30 %, we are satisfied with 8.7 % monthly return, and are not going to tolerate a loss greater than 4.3 % (of course, if you are trading with leverage, you should multiply these figures by it).

The position entry rule is very simple: we are going to buy stocks with high IVX (>= 60 %) and sell low ones (<= 20 %).

Historical performance

Below we chart the historical performance for each month, starting January 2003 till April 2004. The market was quite bullish starting in March 2003, so if the strategy does work, we are to expect stable results. The returns for Buy strategy range from -2 % to 18 %, with the average value of 6.8 % monthly - have a look at the chart:

Strategy return - Buy stock with high IVX

Though not as stable as you would wish for, still buying high IVX was a good thing recently. Note the sharp drops and jumps in average returns - 12 % one month can be followed by 0 % the next one!

As for the selling low IVX, well, the chart demonstrates that this isn't that good of an idea since January, 2003 :

Strategy return - Sell stock with low IVX

The returns weakly oscillate around zero - the average for the period is only 0.3 % monthly. Well, maybe we should've use more aggressive trading strategy for short selling. We'll try to bring more light on this in further newsletters.