Tuesday, December 27, 2011

Risk indicators

During the financial crisis of 2008, I wrote about how I watched some risk indicators such as the VIX or the TED spread  to decide what leverage I should use for my trading strategies. It turns out that this procedure is just as critical for the current crisis that began in August 2011. In fact, more than leverage-determinants, they can be used as the all-important variable that determines whether a certain strategy should be run at all. (What's the point of running a model that you think will lose money with low leverage?)

There are now more than a few of these risk indicators to pick from. Besides the VIX and the TED, there are the VSTOXX (EURO STOXX 50 Volatility), the VXY (JPMorgan G7 Volatility Index), the EM-VXY (JPMorgan Emerging Market Volatility Index), the ETF's ONN and OFF, and probably many more that I haven't heard of yet. 

A lot of academic research has been done on whether we can devise "regime switching" models based on some complicated pattern-recognition algorithms to decide whether a market is in a certain "regime" which favors this or that particular model or parameter set. And often, these regime switching models rely on the recognition of some complicated set of patterns in the historical price series. Sorry to say, I have not found any of these complex regime switching model to have any real out-of-sample predictive power. On the other hand, my research shows that some of the aforementioned simple risk indicators will indeed prevent some trading models from falling off the cliff.

But which of these indicators are applicable to which model? This is not so obvious. For example, you might think that the EM-VXY would be an ideal leading indicator for Forex trading models that involve emerging market currencies, but I have found that it is only a contemporaneous (and thus useless) indicator to mine. Another example, I said during the 2008 financial crisis that VIX seems to be a useless contemporaneous indicator for equities trading models, but strangely, it is a good leading indicator for FX models. In contrast, the TED spread that everyone were obsessed about in 2008 shot up to over 300 bps then, but never went beyond 100 bps this time around. So really only rigorous backtesting can guide us here.

What risk indicators do you use? And have you really backtested their efficacies? Your comments would be very welcome here.