We have updated our privacy policy and terms & conditions. Find out more here.
5
 

Protecting High Yield Bond Investments With VIX/VXV Based Timing

By  |  Bonds  |  Nov 12, 2012 07:31PM GMT  |   Add a Comment
 
AA
+
-

The holy grail of investing is a market timing method that gets you out of the market on bad days and gets you in for the good days. There are innumerable methods for doing this, ranging from slogans, Sell in May and Go Away to closely guarded multi-factor proprietary algorithms.

The worst methods have no apparent causal relationship between the predictor and the thing being predicted. A non-stock market example is the “Redskins Rule.” Between 1940 and 2008 if the Washington Redskins football team won the Sunday before the election the party that won the popular vote in the prior election won the presidency -- 17 out of 18 times. After Obama’s re-election this rule is now 17 of 19. These non-causal rules are just coincidence, if you look at enough data you will find them everywhere -- and they mean nothing.

Most stock market timing methods are based on price action -- things like moving averages, technical chart indicators, price/earnings ratios, or pattern recognition. At least they have some sort of connection to the stock market.

Recently I’ve been looking at volatility metrics for predicting market action. The CBOE’s VIX index gets a lot of attention, but using absolute values of the VIX to trigger investments is almost certainly useless. On the other hand, volatility prices over different time frames, often called the term structure, does show significant predictive value.

In a truly bearish market the short term expected volatility, typically cheaper than longer term volatility, climbs higher than the longer term value. This behavior is shared between flavors of VIX (e.g., the one month VIX & its three month version VXV), VIX futures, and the implied volatility of same strike options of different months. The chart below from VIX Central shows the progression in VIX futures prices from before the May 6, 2012 Flash Crash through the 7th.

Historical Prices
Historical Prices

A simple metric that captures this behavior divides the short term volatility number by a longer term number. If the ratio is below one the market is relatively calm, if above one the market is especially nervous. I’ve been using the CBOE’s VIX and VXV indexes as a convenient way to implement this volatility metric.

I’ve been running simulations using the VIX/VXV ratio as the entry / exit trigger point for market positions. The chart below shows the price performance of the speculative bond fund JNK, since its inception in 2008 compared with SPY, which tracks the S&P 500.
JNK Price Performance
JNK Price Performance

JNK’s performance would be disappointing if it wasn’t for its high dividend payouts, averaging 10% (!) per year. This next chart shows JNK’s performance if you had closed your JNK position whenever the VIX/VXV ratio at market close was greater than 0.917, re-entering when the ratio at close was below that level.
JNK Relative To VIX/VXV
JNK Relative To VIX/VXV

This strategy would have enabled you to avoid the entire 2008/2009 meltdown, plus adding about 3% of extra performance in 2010 through 2012.

Why 0.917? There’s nothing magical about it. It was just the best compromise choice over the last three years. The chart below shows the performance for JNK for all realized VIX/VXV levels for 2010, 2011, and 2012.
JNK And All Realized VIX/VXV Levels
In my simulations this threshold worked well for high yield bond funds (JNK, HYG), high dividend funds (SDY), inverse volatility (ZIV, XIV) and general equity (SPY).

Eventually, perhaps tomorrow, this heuristic will stop working, but for the time being it’s a good tell for the market.

Disclaimer: Fusion Media would like to remind you that the data contained in this website is not necessarily real-time nor accurate. All CFDs (stocks, indexes, futures) and Forex prices are not provided by exchanges but rather by market makers, and so prices may not be accurate and may differ from the actual market price, meaning prices are indicative and not appropriate for trading purposes. Therefore Fusion Media doesn`t bear any responsibility for any trading losses you might incur as a result of using this data .

Fusion Media or anyone involved with Fusion Media will not accept any liability for loss or damage as a result of reliance on the information including data, quotes, charts and buy/sell signals contained within this website. Please be fully informed regarding the risks and costs associated with trading the financial markets, it is one of the riskiest investment forms possible.

Add a Comment

 

Comment Guidelines

We encourage you to use comments to engage with users, share your perspective and ask questions of authors and each other. However, in order to maintain the high level of discourse we’ve all come to value and expect, please keep the following criteria in mind: 

  • Enrich the conversation
  • Stay focused and on track. Only post material that’s relevant to the topic being discussed.
  • Be respectful. Even negative opinions can be framed positively and diplomatically.
  •  Use standard writing style. Include punctuation and upper and lower cases.
  • NOTE: Spam and/or promotional messages and links within a comment will be removed
  • Avoid profanity, slander or personal attacks directed at an author or another user.
  • Only English comments will be allowed.

Perpetrators of spam or abuse will be deleted from the site and prohibited from future registration at Investing.com’s discretion.

SPDR S&P 500
 
 
 
Are you sure you want to delete this chart?
 
 
 
Are you sure you want to delete this chart?
 
 
 

Successfully Reported

Thank you. This comment has been flagged for a moderator.
_touchLoadingMsg