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Thursday, February 25, 2010

Using VIX for volatility correction

Market neutral strategies often rely on a relative mispricing of two instruments. One of the challenges I've been facing is how to keep this mispricing constant in time, allowing it to stretch much further before initiating a trade in times of high market volatility.
A solution I've come up with is using the VIX index as a correction measure. It seems to work much better than a moving window estimation based on the data itself.  The formula I'm using for correction is  C = (100-VIX)/100 . The spread is then multiplied by C.
 
Upper graph: VIX , lower graph : real and corected spreads.

Notice how the corrected spread remains stable through the end of 2008.

P.S. The spread shown is a relative mispricing in time an not an actual X/Y ratio.
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2 comments:

  1. AnonymousFebruary 26, 2010 at 3:41 AM

    I like this concept - what spread is it you are testing there? It looks very stable indeed!

    cheers

    Ramon

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  2. sjevFebruary 26, 2010 at 3:47 AM

    @Ramon: I've anticipated the question about the spread stability ... To disappoint you a little, it is not an 'absolute' spread (X/Y), but rather a relative spread (movingAverate(X-Y)). The absolute spread has pretty much drift, however, it is still very tradeable.

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