What's the Compelling Risk-Reward Opportunity in Periods of Heightened Volatility?

Introduction

Having finished a study on the past buy-and-hold returns with 60 different VIX levels over the past 4.5 years, I'd like to share the conclusions based on the SPY tracker, the SPLV (low-volatility tracker) and SPHB (high-beta). A conclusion for our entire watchlist will be shared in one of the next articles.


I sampled data on their past performance (1-month, 3-month, 6-month and 1-year forward return based on a particular VIX level (high or low) and the results are fascinating. Predicting future stock returns is always tricky and needs to be taken with a good grain of salt. Nevertheless, Option Generator believes that the VIX tells us the most relevant information regarding future risk-reward ratios, forward buy-and-hold performance, and thus market sentiment.

(Source: Option Generator Research)


SPY Tracker

Absolute returns

The first results I'd like to present to you:

(Source: Option Generator Research)

As one can see from the graph, buying the SPY when the VIX is above 15% generates superior returns relative to buying into low-volatility strength. Moreover, between 15% and 20% there is a noticeable edge compared to buying in the 15%-sub levels from a forward 1-year perspective. In the short term, on a 3-month basis, the >25% VIX environments are set to reward new buy-and-hold positions generously. This seems logical but also contradicting since most investors liquidate or reduce their positions when the VIX is elevated, otherwise there wouldn't be a sizable correction.


Sharpe Ratio

The Sharpe Ratio indicates the relationship between risk and reward. Again, buying when the VIX is lower than 15% does not pay off in terms of getting enough bang for your buck. Buying when the VIX exceeds the 25% threshold results in a forward 3-month Sharpe ratio of 2.23 or 4 times the average in all circumstances. Stated differently, after a spike in the VIX to 25+%, the three-month risk/reward is very favorable for new buy and hold positions.

(Source: Option Generator Research)


% Positive Periods

Moreover, the returns when buying equities into elevated VIX-readings are very consistent. Our win rates are substantially higher, leading to positively skewed risk/reward profiles as shown above. When the VIX exceeds 25%, 100% of all observations resulted in positive 3-month, 6-month and 1-year returns. These numbers are well above the average in all circumstances of 74.5%, 84.8% and 78.6% respectively.

(Source: Option Generator Research)


SPLV

Absolute returns

What does the picture for low-volatility stocks look like? As many readers of the OG website know I'm a big proponent of selecting minimum-volatility stocks because of smaller negative outlier risks. Today, the VIX is still well above the 25% barrier indicating investors can expect superior results over the next 3-month, 6-month and 1-year time frame.


Not surprisingly, our elite performers watchlist that we provide to our premium members - based on lower-than-average volatility for the entire portfolio - has generated far greater returns over the past months.

(Source: Option Generator Research)


Sharpe Ratio

The Sharpe Ratio points to an even brighter picture than the SPY's. Today's market environment is full of opportunity if one sticks to the mechanics of solely focusing on the best-in-breed stocks with less volatile share prices.

(Source: Option Generator Research)


SPHB

Sharpe Ratio

Retail investors but also professionals, looking to capture an outperforming fee, focus way too much on volatile stocks that carry higher risk. Do elevated profits go with higher risk? In terms of the Sharpe Ratio, high-beta stocks boost a decent risk/reward ratio during the 3 months after a spike in the VIX. That edge, however, is short-lived. Therefore, one would expect risky underlyings to benefit the most from a steep market downturn, but the risk-adjusted outperformance relative to the entire benchmark decreases faster than initially thought.

(Source: Option Generator Research)

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