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Hey everyone,
I have a few questions about drawdown control.
I have been forward testing a volatility trading strategy, that trades UVIX and SVIX. It is a mean reversion strategy, nothing too complex, but has a crazy CAGR, but an annualised volatility of 46%. Sharpe is still above 2 however.
Tested on most recent regime, roughly last 2.5-3 years. Performed great. Had a worst drawdown of 26%, bounced back every time, however data does not go back enough to test structural changes like 2008, covid crash in 2019/2020, start of war in Ukraine. Did not know how it was going to perform given such black swan events. Worst month drawdown was 13% nonetheless. I found that tolerable.
US picks a fight in the Middle East, as you all know: strategy was up almost 30% YTD when that happened. Decided not touch it since it’s a system that has worked in the past. Equity curve is now a triangle. Now sitting at -5% performance (DD of like 32% something like that).
I don’t think the strategy is fundamentally broken. Also don’t think there are any structural changes in the market now that would lead the strategy to stop working completely. The strategy just sucks at transitioning between regime shifts, especially those that happen incredibly quickly, like the current one, with huge volatility shocks. Makes most money in calm markets, either extreme (big up or big down) yields poor performance. Have tested and validated this.
Have been looking at how to eliminate drawdowns all weekend, or at least limit risk. SL does now work: large gaps after hours means stop orders don’t get filled at required price. Volatility scaling doesn’t work, reduces returns way too much to make it worthwhile, without huge improvements to drawdown. Tried testing VIX levels to stay out of market, VIX changes, volatility term structure changes, volatility surface curvature changes, constructing new indicators, even went as far as ML methods to predict volatility transitions. Regressions and stats analysis shows that some of the above have a ‘statistical impact’ on contemporary and future returns, but does not actually translate to a better performance when utilised.
Conclusion: Nothing works. Drawdown stays the same, performance gets cut in half in most cases. Using less leveraged ETFs works, but sharpe ratio doesn’t improve when doing this, drawdowns are better nominally but not on a risk adjusted basis.
Only option I can come up with: add more uncorrelated strategies to reduce drawdowns in a portfolio. Good option, problem is I have multiple in the pipeline and they are still 3-6 months from completion. This isn’t a quick fix is what I mean. I have work, only time I can dedicate to this is on the weekend, and want to prevent this from happening again if possible asap.
Hence my question: does anyone know if there is anything in the literature or something you may have found that limits drawdowns of mean reversion strategies? Particularly those that trade volatility? Or perhaps what other options can I explore? Even a pointer in the right direction would be good.
Also would be interesting to hear if anyone was ever in this scenario, let me know your stories!
Testing starting the strategy at the worst drawdown time, is one thing in a backtest, but completely different when actually putting money on the line. Good learning experience for emotional control nonetheless.