History shows that there can be profit in panic.
Generally, extreme market selloff see an increase in correlation across asset classes as investors panic in unison. However, most of the time, the spike in implied volatility was largely confined to equity markets.
India Volatility Index spiked upwards of 35 percent during 2014 following the election uncertainty. Outliers were also seen in 2015 and 2016 when volatility spiked above 25 percent. Traders prefer to bet directional moves during such extremes.
But, how should we define “extreme”? The mean volatility since early 2017 was above 14 percent. The strategy is to buy Nifty Index following implied volatility spikes.
India VIX: India Volatility Index
Backtesting & Assumptions
The strategy is to buy Nifty Index when the volatility cooled off from the threshold. To test this concept, I performed a quick backtesting using Python from January 2017 to March 2019 with the following assumptions:
1. Backtesting assumes zero friction.
2. Trade was entered on the day when the volatility cooled off below 15 percent.
3. No stop-loss or money management rules were applied.
4. Multiple positions were allowed and all positions were held for the next 90 trading sessions.
5. Trade was left untouched and all statistics were recorded between entry and expiry levels.
Backtesting Results
{‘Total Trades’: 13, ‘Positive Trades’: 11.0, ‘Negative Trades’: 2.0, ‘Average Return’: 5.67, ‘Maximum Return’: 14.36, ‘Minimum Return’: -4.57, ‘Hit Ratio’: 84.62}
Buying the Nifty50 Index when the India VIX subside below 15, a rare enough occurrence over this time period and an indication that a spike had occurred, would have returned an average of 5.67 percent over the this period. The trading signal occurred 13 times and there was a gain after 11 of them (including the two recent open trades), though a loss after 2.
The India Volatility Index, a gauge of investor fear, often surges to extremes near significant market lows. However, it may take time for this fear to subside before equity markets are ready to rally again.
Investors who bought the Nifty50 Index after volatility cooled off from the threshold level made an average return of more than 5 per cent over the next 90 trading sessions, with the strategy turning a profit about 84 percent of the time during the past two years.
For more volatility stories and strategies, also read:
Will 2019 Be The Year of High Volatility? http://kannansingaravelu.com/will-2019-be-a-year-of-high-volatility
How To Harvest Volatility Risk Premium in India’s Nifty Index http://kannansingaravelu.com/how-to-harvest-volatility-risk-premium-in-indias-nifty-index
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