This Unique Volatility Indicator Provides a Tradable Edge in All Markets
In a paper called "Value and Momentum Everywhere," a team of respected researchers found that "value and momentum ubiquitously generate abnormal returns for individual stocks within several countries, across country equity indices, government bonds, currencies, and commodities."
This conclusion is so widely accepted that value and momentum are considered to be anomalies to the Efficient Market Hypothesis (EMH). Proponents of EMH believe markets efficiently price stocks using all available information. The strictest form of the hypothesis says that no individual could beat the market because each stock is trading at exactly the right price at all times.
However, researchers have repeatedly demonstrated that investors can beat the market by applying value and momentum strategies. We believe that volatility can also be used to outperform a buy-and-hold strategy.
Recently, we introduced the Income Trader Volatility (ITV) indicator and provided test results showing that the indicator offered useful buy and sell signals on stocks in the United States.
This week, we expanded our testing to include a larger group of stocks in the U.S., stocks traded in seven markets overseas, currencies and futures. The list of exchanges was limited to data that we have available, and we used all of the countries we have data for. The same is true for currencies and futures where we used all of the data we have available.
ITV is calculated by finding where the most recent close lies relative to the recent price action. For example, with daily data, if the close is the lowest low in the past month, ITV would be at 100. ITV would be low when prices are near one-month highs. The same process can be applied to weekly or monthly data.
For ITV signals, we bought when ITV fell below its 20-week moving average. The same rule was applied in all markets and short trades were not included in the results. A random trading signal would be right about 50% of the time and wrong 50% of the time.
In every single test, ITV offered an advantage to traders. Ten years' worth of data was tested on each market, using all of the stocks provided by Trade Navigator. Each exchange included at least 300 stocks. The percentage of winning trades for each test is shown below.
These tests do not prove that ITV is a perfect indicator, but they do show that it is useful. Volatility rises when prices fall, and in every market we tested, that insight offered an opportunity to profit.
There are a number of ways to improve this strategy. In Russell 3000 stocks, the average winning trade lasts about 10 weeks. Losing trades last an average of 22 weeks. Closing a trade after 11 weeks, for example, could help reduce the size of losing trades.
Options traders may find ITV to be especially helpful. When volatility is high, options prices will be high. That is true because volatility is an important factor in options pricing models. ITV can be used to spot times when volatility is turning down after reaching an unusually high level. This should be the ideal time to sell options since the price of the option should be high and the risk of the trade ending in a loss is small.
Options buyers would want to take positions when ITV is low since that would be the time when options prices should be low.
VIX can also be used to find times when the general level of market volatility is high or low. The advantage of ITV is that it can measure volatility for individual stocks or ETFs. Traders are then able to find high-volatility opportunities even when market volatility is low.
Amber regularly uses this indicator in Income Trader when she searches for the best options plays each week. A testament to the power of this indicator is her track record -- all nine of her closed positions are winners. Even more impressive, Amber's average annual return is 87.5% on her Instant Income trades. You can learn more about Income Trader and even sign up to get her next issue by clicking here.