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Three Stages of Developing a Volatility Trading Strategy

The three stages of developing a volatility trading are: basic idea, absolute return performance improvement and maximum drawdown reduction.

The strategy trades UVXY long/short in the daily timeframe. The strategy is called VOLZ and it is based on contango and backwardation conditions in VIX. This is not a data-mined strategy but it is based on sound technical considerations. A volatility adaptation mechanism is used to boost returns and then the maximum drawdown is adjusted by applying risk management.

The period of all backtests is from 01/03/2012 to 01/22/2021 and there is no commission included.

Stage 1. The basic idea

The basic idea shows high potential although volatility of strategy returns is high and so is the maximum drawdown. However, the large annualized return offers room for improvement. Since 2012, the strategy has only one losing year (2018 down 23.8%) and in 2020 return was 328%!

Stage 2. Performance improvement

FAQ: Why does performance improvement come before maximum drawdown reduction?

Ans: When maximum drawdown is reduced, the annualized return is also reduced in most cases. It is always better to start from a higher annualized return level and then reduce drawdown.

A significant increase in annualized return was achieved by adding one relatively simple rule to provide adaptation capability to the strategy. The gain in annualized return is 34%, from 69.4% in Stage 1 to 93% in Stage 2. However, volatility and maximum drawdown still remain at high levels. Note that the rule addition has improved significantly returns for 2015 and 2016 while there was no major impact to returns of other years and especially of 2020.

Stage 3. Reduce maximum drawdown and volatility

Now that we have maximized returns, we can go ahead and minimize risk. We have to be realistic with this step and actually the final result may depend on developer risk aversion profile. Here we provide an example of what we thought it was a good trade-off. The method is general and can be adjusted to other profiles.

Volatility drops by 67%, from 88.3% to 30.2% while maximum drawdown drops from -62% to -37% on a closing price basis. The annualized return drops from 93% to 31%, or a 67% reduction. Note that the maximum drawdown occurs in 2020 and follows a trade that generated 211% return, so the strategy gave back less than half of the gains of that trade and that caused the maximum drawdown.  Up to 2019, the maximum drawdown was about 22% on a closing price basis.

Summary

Below is a table of the strategy performance in the three stages followed above.

STAGE 1 STAGE 2 STAGE 3
CAGR 69.4% 93.2% 31.2%
MAX. DD -66.8% -62% -37%
AVG. DD -24.1% -18.1% -9.4%
VOLATILITY 89.4% 88.3% 30.2%
TRADES 117 99 99
LONG TRADES 58 49 49
SHORT TRADES 59 50 50
WIN RATE 50.4% 51.5% 51.5%
SHARPE 0.78 1.05 1.03

As noted above, the maximum drawdown of the strategy in all stages is due to a correction after a single trade gain of about 212% in early 2020.

VOLZ strategy is available for sale to professional traders and hedge funds only. Click here for more details. 


Charting and backtesting program: Amibroker

Data provider: Norgate Data

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