Market Timing Rule with Implied Volatility Index

    This market-timing strategy uses the implied volatility index as an indicator to predict future stock market return. In this strategy, stocks are supposed to be sold when the indicator rises above the predefinded threshold value, and vice versa. It also has “delay day” and “waiting day” settings.

    The risk-return theory argues that, under certain conditions, the market risk premium is positively correlated with the variance of the market portfolio. French, Schwert, and Stambaugh (1987) find that, if there is an unexpected increase in market volatility, expected volatility is revised upward for future periods. Hence, given that the market risk premium is positively related to the expected volatility of the market portfolio, discount rates will increase and in turn reduce stock prices. Thus, a negative relation between (unexpected) volatility changes and returns is induced. The performance of timing rules based on volatility changes has been investigated, for instance, by Copeland and Copeland (1999), who test the feasibility of market timing based on changes in the implied volatility index, VIX, and find profitable strategies.   

    In this Strategy, for the implied volatility index, falling below a certain threshold is considered to be a switch signal from holding cash to investing in S&P 500 Index, and vice versa. If the same switch signal persists for “delay days”, we switch the trading position. And in the succeeding “waiting days” we keep the position ignoring the new switch signals. The signals are examined every trading day.

    VIX is used as the implied volatility index.  The threshold can set to be certain fix values or SMA (Simple moving average) of certain days. And the Portfolio StartDate should not be set to the date earlier than 01/02/1990 due to lack of data.

Parameters used in the created portfolio:

Indicator: VIX (implied volatility index)

TresholdValue: 15, 30, SMA 30days (default), SMA 120days

WaitingDay´╝Ü1 day, 5 days (default)

DelayDay: 1 day, 5 days (default)

BuySecurity: ^GSPC (default)

Similar Strategies in ValiFi:

See Also

Relative Working Papers: 

 

Relative books:

 

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