Trading VIX Options with the s1 Signal
VIX is a non-tradable index, but has tradable futures, that represents the expected 30-day, forward-looking, annualized 1-standard-deviation move in the S&P 500. More simply, if VIX is currently 25, there is a ~68% chance the S&P 500 will be within +/- 6.31% of its current price (formula: VIX * sqrt (30 / 365) = expected 1-standard-deviation move) 30 days from now.
There are well-documented strong negative correlations between VIX and the S&P 500. When the S&P 500 increases, VIX generally decreases. When the S&P 500 decreases, VIX generally increases.
Based on this correlation and the material outperformance the s1 signal has had, and continues to experience, trading S&P 500 options, is there an advantage using the s1 when trading VIX options?
As a sidebar, VIX options use the corresponding VIX futures contract as their underlying, not the VIX itself. Said another way, a deep-ITM position of 10 VIX options with a delta of 0.99 will experience essentially the same price movement as a single /VX contract with the matching expiration date.
Let’s run some backtests and find out.
In this post we’ll take a look at the backtest results of opening one VIX short or long, put or call, 30 DTE position each trading day from Jan 3 2007 through July 31 2022 and see if there are any discernible trends.
- Backtest duration is limited due to the range of my dataset (earliest date: Jan 3 2007)
- Equity curve charts will be grouped by position type (short puts, short calls, long puts, long calls) and binned by entry mechanic (daily entry, s1 = true, s1 = false)
- Duration target is 30 DTE in order to approximate performance of trading the /VX front-month contract
- Positions opened will be 30% ITM. A common application for trading VIX options and VIX futures is for hedging movements in existing S&P 500 positions (or positions with a similar correlation to the S&P 500).
- Strategy will be benchmarked against a SPY buy/hold (total return) | 100% allocation, no leverage
There are 13 backtests in this study evaluating over 32,000 VIX long and short, put and call, 30 DTE 30% ITM (call) and OTM (put) leveraged (for short strats) trades.
Let’s dive in!
Contents
Summary
There is a material risk premium to be earned by accepting “unlimited loss” (read: blowup) risk by selling ITM VIX calls. The s1 signal yielded a material improvement in navigating the blowup risk while harvesting the risk premium.
The s1 signal yielded an 8.4x improvement in capital efficiency by selling ITM VIX calls only when s1 = TRUE vs agnostically selling a call every trading day.
The s1 signal yielded a 2.0x improvement in capital efficiency by buying ITM VIX calls only when s1 = FALSE vs agnostically buying a call every trading day.
Selling 30% ITM VIX calls when s1 = TRUE and buying 30% ITM VIX calls when s1 = FALSE yielded over 2x the CAGR of buy/hold SPY and outperformed with regard to max drawdown duration, but underperformed with regard to sharpe ratio and max drawdown.
Systematically buying or selling far OTM puts on VIX yielded nominal price action relative to call instruments.
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Methodology
Strategy Details
- Symbol: VIX
- Strategy: Short Put, Long Put, Short Call, Long Call
- Days Till Expiration: 30 DTE +/- 15, closest to 30
- Start Date: 2007-01-03
- End Date: 2022-07-27
- Positions opened per trade: 1
- Entry Days: daily entry and each trading day in which s1 signal = TRUE, FALSE
- Entry Signal: s1 signal
- Trade Timing: 3:46pm ET
- Strike Selection
- Long Calls: 30% ITM +/- 500bps, closest to 30% ITM
- Short Calls: 30% ITM +/- 500bps, closest to 30% ITM
- Long Puts: 30% OTM +/- 1500bps, closest to 30% OTM
- Short Puts: 30% OTM +/- 1500bps, closest to 30% OTM
- Trade Exit
- Hold till expiration
- Max Margin Utilization Target (short option strats only): 100% | 5x leverage
- Max Drawdown Target: 99% | account value shall not go negative
Assumptions
- Margin requirement for short CALL and PUT positions is 20% of notional
- Margin requirement for short STRADDLE and STRANGLE positions is 20% of the larger strike
- Margin requirement for short VERTICAL SPREAD positions is the difference between the strikes
- Margin requirement for short CALENDAR SPREAD positions is 20% of the short option (short option expires after the long option)
- Margin requirement for long CALENDAR SPREAD positions is the net cost of the spread (short option expires before the long option)
- Early assignment never occurs
- There is ample liquidity at all times
- Margin calls never occur (starting capital is set using hindsight bias so that max margin utilization never exceeds 100%)
- Apply a 20% discount to displayed results. For example, if a strat depicts a CAGR of 10%, assume that it’ll yield 8% in practice.
Mechanics
- Prices are in USD
- Prices are nominal (not adjusted for inflation)
- All statistics are pre-tax, where applicable
- Margin collateral is invested in 3mo US treasuries and earns interest daily
- Assignment PnL is calculated by closing the ITM position at 3:46pm ET the day of position exit if managed early or 4:00pm if held till expiration
- Commission to open, close early, or expire ITM is 1.00 USD per non-index underlying (eg: SPY, AAPL, etc.) contract
- Commission to open, close early, or expire ITM is 1.32 USD per index underlying (eg: SPX, RUT) contract
- Commission to expire worthless is 0.00 USD per contract (non-index and index)
- Commission to open or close non-option positions, if applicable, is 0.00 USD
- Slippage is calculated according to the slippage table
- Starting capital for short option backtests is adjusted in $1000 increments such that max margin utilization is between 80-100%, closest to 100%, of max margin utilization target
- Starting capital for long option backtests is adjusted in $1000 increments such that max drawdown is between 80-100%, closest to 100%, of max drawdown target
- Positions that have an exit date beyond the backtest end date are excluded
- For comprehensive details, visit the methodology page
Results
Starting Capital
Margin Utilization
Hindsight bias was used to maximize Reg-T margin utilization (and maximize max drawdown for long strats) for each strategy. This allows a “best case” scenario for the option strategy to outperform the benchmark.
Also displayed is the date in which each strategy experienced maximum margin utilization.
Premium Capture
s1 = TRUE signal had higher rates of premium capture vs daily entry for short call positions.
s1 = FALSE signal had higher rates of premium capture vs daily entry for short put positions.
Win Rate
Monthly Returns
Max Drawdown
Max Drawdown Duration
Average Trade Duration
Compound Annual Growth Rate
Annual Volatility
Sharpe Ratio
Profit Spent on Commission
Total P/L
Overall
Discussion
When it comes to hedging declines in S&P 500 positions, VIX long calls asymmetrically outperform VIX short puts. This makes sense since the short put’s profitability is capped to the premium received while the long call doesn’t have the same cap. Focusing on this asymmetry, opening VIX long calls only when s1 = false provided an incredible hedge against S&P 500 downside moves.
Similarly, if one wants to capture VIX decay, opening an “unlimited loss” short call provides a notable reward for taking this risk vs buying long puts. When focusing on when to take this risk, opening VIX short calls only when s1 = true provided substantially more total return than holding the S&P 500.
What if we combine these two strategies, opening a short call on days when s1 = true (bullish) and opening a long call on days when s1 = false (bearish)?
Starting Capital and Leverage
By combining both strategies, the minimum amount of capital needed to execute the strategies decreases.
Win Rate Stats
When both strategies were combined, the win rate was a little over 50% and was very close to that of SPY’s daily term win rate.
Profit and Loss Stats
It may be unintuitive, but mixing strats that have positive and negative PnL characteristics can cause synergies that outperform each strat on its own. This is a prime example of diversification of strategies.
The premium capture attribute for the combined strat can be ignored. Premium capture is only a measure of premium retained for short strats. Since this was a blend between long and short premium, the number is unrepresentative of anything.
Capital Efficiency
To calculate capital efficiency of the s1 signal, let’s strip out the impacts of interest on margin collateral and commissions and look at strictly the PnL of the options themselves. The formula is:
( ( strat return / benchmark return ) / ( strat occurrences / benchmark occurrences ) -1 ) * 100
s1 = TRUE was paramount in improving capital efficiency of short call strats.
Performance Stats
Despite the massive outperformance with regard to total return, risk-adjusted return underperformed.
Arguably, any strat that has an “unlimited risk” quality should have “N/A” for the sharpe ratio since it’s qualitatively infinite and thus undefined. Alas, since this is a quantitative study, a number is to be presented.
Risk Management
If a trader was willing and able to stomach the near-account-zeroing max drawdown, they would have been rewarded by a record-low max drawdown duration.
Distribution of s1 signals
The s1 = TRUE signal, while suggesting order entry on roughly half the trading days since 2007, is not evenly distributed throughout time. Here’s a breakdown of participation rate by year:
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Additional Resources
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August 28, 2022 @ 9:56 am
Very cool stuff! A delight to read.
Some questions and remarks:
Do I understand correctly that SC TRUE LC FALSE strategy had days with simultaneously opposing trades? That is, you would buy calls on FALSE days and then switch to selling calls on TRUE days, while keeping your long call positions. Right?
*Putting aside your point about the SR figure for naked call strategies* –
Looking at the low SR of SC TRUE LC FALSE strategy would paint a false image because the variance of this strategy comes mostly from the right tail of the VIX distribution. When buying VIX calls, you are looking for these kinds of moves. Using something like a Sortino Ratio would be a better fit, no?
Would you mind explaining what caused the outperformance of the FALSE LC strategy over the TRUE and daily entry LC strategies around 2008 and 2020? At first glace it seems odd, because the daily entry strategy should have been exposed to the tail event and so perform similarly to the FALSE LC strategy.
I imagine that the TRUE and daily entry strategies suffered from buying vol when it was already richly priced, thus losing much of their gains, while the FALSE LC strategy bought vol cheaply and stopped after the tail event.
Last remark: it’s pretty obvious to me why the SC strategies are extremely profitable – I would never trade them! Too risky! You need both lots of capital and guts to makes these work. No thank you (:
August 30, 2022 @ 12:32 pm
Glad to hear!
Yes, that is correct. As the signal flips between true and false, existing positions remain open. Thus a trader will indeed have opposing trades.
Agree, as long as the trader doesn’t have any objections to upside vol (usually a non-issue for retail, but institutional folks with PnL mandates may have their hands tied). Adding Sortino Ratio has been something I’ve considered from time to time. MAR Ratio and Calmar Ratio have also been considered.
The VIX long call when “s1 = false” strategy performs well in a bearish environment. We can see a similar equity curve when reviewing the “short SPY when s1 = false” strat at https://spintwig.com/spy-s1-signal-equity-backtest/. In essence, s1 = false is a bearish indicator.
It’s true the that the daily entry strat had the same exposure to tail events, but the amount of capital needed to successfully run the daily-entry strategy (eg: hedging all the time) for the duration of the backtest was almost an order of magnitude greater (see starting capital section). The starting capital is normalized to “the minimum amount needed to execute the strategy” a la hindsight bias. The tail events that do happen are drowned out by all the other capital in the account that is needed just to cross the finish line.
August 31, 2022 @ 9:10 pm
Thanks for this study.
I didn’t understand how we came to this conclusion?
“Focusing on this asymmetry, opening VIX long calls only when s1 = false provided an incredible hedge against S&P 500 downside moves.”
I tried to understand the data and didn’t arrive at the same. Can you elaborate?
September 1, 2022 @ 12:10 am
Hey Pratap!
Sure — the 3rd chart in the “overall” section depicts the performance of opening a VIX long call when s1 = false (maroon line). These are substantial spikes to the upside in response to downward moves in SPY, far greater than the upward moves from opening VIX short puts when s1 = false.
In my interpretation of the data, I’m weighing the magnitude of positive return from the VIX long call over the fact that the VIX short put hedge actually experienced a positive total return.
If a trader is holding positions that have a more symmetric return profile (eg: not low-delta bullish short options), then the VIX short puts when s1 = false may be a better strategy.
September 1, 2022 @ 12:19 am
Got it thanks! The comment was in relation to the short put.
That said, the long call still bleeds and results in overall negative return even accounting for the gains during SPY drawdowns. Is that correct?
September 1, 2022 @ 12:26 am
Yes, that is correct.