# Premium Model

Trading Inverse Volatility and ETFs (US)Take advantage of Volatility and leveraged ETFs by trading this model that uses both rolling yield, fundamentals, economic indicators and technical analysis to determine the best ETF to trade for the short term, switching between inverse volatility ETF (SVXY) or leveraged ETFs when market conditions are favorable for the upside to other asset-classes ETFs (like fixed income) when market conditions are uncertain or signaling increasing volatility.

This is a low turnover model. The model rebalances weekly and it trades one ETF at a time.

Before elaborating on the strategy or specific products used, it’s important to understand how the volatility concept works, which is not the same as how a stock price (which is a representation of a company) goes up or down.

I like how Vance Harwood once described how complex this is: “First you have stocks, then you have the S&P 500, then you options on the S&P 500, then you have implied volatility calculations, then you have futures on volatility, then you have ETFs with rolling mixtures of futures on volatility (VXX), and then you have the inverse (or the short) of that.”.

Breaking it down:

The S&P500 is an American stock market index based on the market capitalization of 500 large companies having common stock listed on the NYSE or NASDAQ. The Options market allows one to buy (or sell) a right (or obligation) on a contract (calls or puts) that typically represents 100 shares of a company. The price of these contracts are affected by implied volatility, which is the estimated volatility of a security’s price. The market’s expectation of 30-day volatility, which is constructed using the implied volatility of a wide range of S&P 500 index options is what makes the Volatility Index (VIX).

So to recap, VIX is the ticker symbol for the Chicago Board Options Exchange (CBOE) Volatility Index, which shows the market’s expectation of 30-day volatility. It is constructed using the implied volatilities of a wide range of S&P 500 index options. This volatility is meant to be forward looking, is calculated from both calls and puts, and is a widely used measure of market risk. Click here for more information regarding Futures Pricing Algorithm.

We rely on volatility products focused for mid-term and short-term futures, which helps us to calculate rolling yield (more on that later).

Once again, the S&P 500® VIX Short-Term Futures Index (VIX) offers exposure to a daily rolling long position in the first and second month VIX futures contracts and reflects the implied volatility of the S&P 500 Index at various points along the volatility forward curve. Click here for the VIX White Paper. The index futures roll continuously throughout each month from the first month VIX futures contract into the second month VIX futures contract. Click here to view more info about VIX Short-Term Futures Index.

The CBOE S&P 500 3-Month Volatility Index (VXV) measures the market’s expectation of 3-month volatility implicit in the prices of S&P 500 Index options with roughly 3 months to expiration. Click here for detailed Description.

Typically (more often than not), the further months volatility contracts are more expensive than the front months, so in this case, we say that the price structure is in contango. This is where ETF products that trade inverse volatility shine: They sell the further month (high) and buy the front month (low), which makes the ETF to appreciate in price due to negative roll yield that price structure. And vice-versa: when the price structure inverts (backwardation), it makes the ETF to drop in price (as it would have to sell low and buy high). This happens when volatility or uncertain conditions build up, causing the VIX index to spike, and the front (current) month contract price to spike as well. A setup where front months are more expensive than back months causes the ETF (and usually the market) to drop as a consequence, which makes the price structure to be in backwardation.

So the model will make use of an Inverse Volatility ETF when there is negative roll yield (sell high, buy low) combined with upward market conditions (based on fundamentals, economic factors and technical analysis) and switch to other asset classes (fixed income) when those conditions are not present. Furthermore, if there is a higher probability of volatility to spike, the model will switch from Inverse Volatility ETF (SVXY) to leveraged ETFs that can benefit from a bullish period.

The short-term inverse volatility ETN (XIV) was terminated when VIX spiked over 115% on February 5th, 2018, and XIV dropped over 80% after hours. On XIV prospect, Credit Suisse stated that the product would be terminated if XIV ever drops more than 80%. When a product shorts anything, there are unlimited risks if the underlying security skyrockets, so although SVXY wasn’t terminated, the possibility still exists. The key is to not be exposed when such events happen, and history has shown that spikes in volatility has typically happened when the price structure is in backwardation. Therefore, since XIV is terminated, one should use the SVXY ETF for exposure to inverse short-term volaility product.

The ProShares Short VIX Short-Term Futures ETF (SVXY) is an ETFs that provides short exposure to the S&P 500 VIX Short-Term Futures Index, which measures the returns of a portfolio of monthly VIX futures contracts with a weighted average of one month to expiration. Click here for details on how SVXY works. This ETF is designed to go up when volatility decreases, but it’s more volatile given the short-term period. As a consequence, this amplifies results – good or bad. An alternative to mitigate the volatility of this ETF is to use the medium-term Inverse Volatility ETN (ZIV), which are mid-term notes – since the contract is further out, it oscillates less than the contracts that will expire sooner – and for this reason, both losses and gains are smaller when compared to the SVXY ETF. This model uses ZIV, but it can be replaced by SVXY if you have a more conservative trading objective.

Inverse volatility ETFs compound returns as it benefits from contango, which is the effect of having negative rolling yield. Having said that, and considering that performance can be indeed significant superior than the market or individual stocks, **it’s important to understand the risks involved with these ETFs, specially the fact that flash crashes might severely affect them and they can be terminated if volatility suddenly spikes at high double-digits or greater. **For this reason, this model uses ZIV when issuing a buy signal for an inverse volatility product, as it will be affected in a smaller scale than SVXY could (and that’s because SVXY focus on short-term volatility, while ZIV focus on medium-term voliatility).

The model attempts to identify when there is a higher probability of the price structure to switch to / remain in contango. It switches to other ETFs when there is a higher probability that contango momentum might diminish (but still remain bullish) and it switches to fixed income types when market conditions are bearish. The model uses volatility price structure to calculate rolling yield, as well as market fundamentals, economic indicators and technical analysis to determine the most appropriate signal.

This is a mechanical model that chooses what to buy and sell based on a set of rules. Therefore, there will be losing trades from time to time. By no means it reflects a broken strategy. No model can outperform at all times, so it’s paramount to have the proper temperament to stick what a strategy that is aligned to your goals and risk tolerance.

**Backtests using ZIV and index ETF:**

Detailed performance simulation and drawdown:

**Backtests using SVXY and leveraged ETF:**

Detailed performance simulation and drawdown:

Performance stats simulation (with ZIV ETN, which is the ETN used in this model):

Trading stats (using ZIV ETN):

Risk Measurement Simulation (using ZIV ETN):

Please note that this is a very volatile model. Please understand what the model entails to, so you can have the proper temperament during drawdown. For example, not how the model underperformed the market in 2010; drawdown was reasonable because this model uses ZIV (it would be doble if one was trading SVXY):

Because the inverse volatility ETFs are invested in futures, there’s a real risk of these products being terminated suddenly case there’s a huge spike in volatility (XIV was terminated after dropping over 80%, volatility would have to rise a lot more to put ZIV at risk of being terminated). Therefore, keep this in mind when deciding how much to allocate to this strategy, and remember the old adage of too many eggs in a single basket. Don’t chase performance and don’t over-allocate your portfolio in this model. There’s a reason why this model has the potential of strong reward – it carries additional risks.

To determine the best ETF to invest for the short term , several components are screened for:

- Volatility futures help to validate momentum (or anticipate changes) regarding the volatility index, by using concepts from this white paper and a variation of the VRP and rolling yield strategies, described on this white paper;

- Fundamentals look for earnings guidance and surprise results for the 500 companies of SP500; If earnings results and guidance are improved, volatility are expected to decline (and vice-versa);

- Economic indicators look for metrics to predict recession and sector rotation that favour different asset allocation;

- Technical analysis help to identify trends and predict changes based on classical patterns regarding market performance and sector performance to identify sector rotation;

The combination of all these different factors produce a score which is then compared to a threshold to determine the probability of volatility increasing and decreasing; the result will determine the ETF to trade.

Using SVXY and leveraged ETFs amplifies results – good and bad; therefore, it’s more volatile (higher drawdown), although it has a better performance year over year; Alternatively, if one wants to reduce volatility, the signals can be replaced with ZIV and index ETFs.

Hi

Is this model available for subscription?

Given the high performance on backtests, this model is on “incubation” phase to validate out-of-sample performance. I expect to launch it for subscription in March. If you click on the Subscribe tab, you can add your email to be notified when the model is available.

Thanks!

Is the model busted?

No, the model continues to work. The model dropped more than the market due to the nature of leveraged ETFs, but it was not invested in inverse volatility products, since the VIX price structure is in backwardation since January 26th. The model takes that into account, and would only consider to buy an inverse volatility ETF (SVXY) if the VIX price structure is in contango. This is obviously a very volatile model, but you can’t outperform the market without volatility – any high beta model will do better than the market when going up and worse than the market when going down. Different simulation shows a max drawdown similar to the market (-50%), so the model continues to behave as expected.