Trading System Lab
Market-neutral VIX-based pair strategy
By Volker KnappMarkets:
Large-cap and small-cap ETFs.System concept:
This month’s system uses a market-volatility measure to determine when to switch between large-cap stocks (e.g., the S&P 500 index) and small-cap stocks (the Russell 2000 index).
Many people believe small-cap stocks tend to outperform large-cap stocks, especially in bull markets. Conventional Street wisdom holds if small-caps are strong relative to large-caps, the large-caps will follow. But as with any tendency, this one doesn’t necessarily always hold true, and it can sometimes invert.
In a paper in the Journal of Investment Management (www.joim.com), Dean Leistikow and Susana Yu put forth the argument that the CBOE volatility index (VIX) has been a useful tool for determining when to switch between large-cap and small-cap stock indices, as well as growth and value stocks. The premise is that when the VIX is relatively high, large-cap stocks tend to outperform small-caps, while the opposite is true when the VIX is relatively low. Leistikow and Yu outlined a market-neutral pair-trading approach that buys a large-cap index and shorts a small-cap index when the VIX is above its 75-day simple moving average (SMA) by a certain percentage (e.g., 10 to 20 percent), reversing the trade when the VIX is below its 75-day SMA.
The following system shortens the moving average look-back period and decreases the percentage amount the VIX must be above or below the average to trigger a switch.System rules:
1. Go long the S&P 500 and go short the Russell 2000 at the close when the VIX closes at least 5 percent above its 63-day SMA (which reflects approximately one quarter of market activity).
2. Go long the Russell 2000 and go short the S&P 500 at the close when the VIX closes at least 5 percent below its 63-day SMA.
3. Exit all positions when the VIX closes within the -5 percent/+5 percent band.
Although the specific SMA length didn’t have a groundbreaking effect on results in testing, 63 days was chosen as a general proxy for medium-term price action — i.e., approximately one quarter (three months) of market activity. For the complete article, see the October 2010 issue of Active Trader magazine. Click here to subscribe.