I have spent many weeks fooling around coding systems to trade the VIX, long and short. I had not looked at the VIX before but the idea of selling calls on volatility to fund managers for a decent premium struck me as a reasonable assumption as to why the VIX contango trade has been so profitable for those who participate.
My most acute concern these days is curve fitting and imaginary patterns. This is most easily achieved via a viral increase in rules and manic back testing of every conceivable parameter. Like trend following, there does at least seem to be some fundamental justification behind the VIX contango trade however.
I have seen some ludicrous VIX systems posted on the internet recently, largely because people have not gone back far enough in their backtesting. That aside, back testing suggests very high returns have been available. These are accompanied by huge volatility and drawdown.
But look, here is what people so often miss.
Almost everyone is trying to shoot the lights out. To grow rich and retire on the proceeds of speculation. And nothing wrong with that.
I believe the mistake they usually make however is that they assume huge returns can be achieved with modest volatility and drawdown – I do not believe that to be the case.
Even the great Medallion Fund is a pretty hairy ride.
The real problem for people with less experience is that they invent rules and change parameters so that in back testing their goal is achieved – high return for low vol and dd.
In my own experience at least, this does not come to pass. I have experienced the horrors of curve fitting at first hand. I have been guilty of leading myself up this naive garden path in the past.
Instead of cooking the books, in my view one is better off doing one of two things. Or a combination of both. If a backtest yields a CAGR of 98% for a huge DD of 76% people will look to invent rules to reduce the drawdown but maintain the returns. In back testing they will surely succeed in this endeavour; in real trading they equally surely will not.
That being the case if you can’t survive a 76% or worse drawdown (who can?) you have two reasonable options.
Trade for peanuts – maybe that is $10,00 in my case, or $100,000 in your case. If you compound, your money grows 30 times in 5 years (in your dreams!). At that stage 76% drawdowns get very destabilising so take some money off the table.
Or look at it another way. Take your entire trading capital and reckon you will devote 10% to this high risk scheme. Leave the rest in a bunch of low risk, short dated bond funds. Every month, quarter or year rebalance to maintain the 10/90 split. Over the long term you would achieve 10 or 11% on your capital for single digit volatility drawdown and single digit volatility.
In short my own feeling is that it is misguided to twist parameters and add rules. Accept such a scheme for what it is (horribly risky and volatile) and trade small.
Not many people will care for my suggestion.