This is a slightly tweaked momentum strategy that involves the normilization of the stock returns using a risk metric. In this example, we will refer to the use of VIX levels for the risk adjustment of returns. Other risk metrics can be used as well such as Value at Risk (VaR). The concept is similar, we adjust the returns using a risk indicator before we sort the universe of stocks based on the returns.
VIX is the ticker of the CBOE Volatility Index, which is a popular measure of the implied volatility of S&P 500 stock options.
- Calculate daily returns of S&P500 stocks
- Calculate average returns per look-back window (e.g. 3-12 months)
- Roll the average returns calculations one day at a time
- Divide average returns by the VIX levels of each trading day
- Sort stocks by adjusted returns – select top n and bottom n stocks
- Track the returns of the n top and bottom performers for your holding period (e.g. 1-mo)
- Estimate your historical returns and volatility and compare them to a benchmark – in this case S&P500 index.
Dividing returns by the VIX levels might not produce meaningful values on an absolute scale but on a relative scale and in order to order the stocks, it provides useful information. More specifically, it downgrades the impact of high returns on very volatile days and upgrades high returns on trading days with less volatility. The concept is similar if using any other risk indicators as mentioned earlier.