How to adapt your trade frequency to market volatility using the $VIX

I just finished my monthly exercise of reviewing closed trades and performance reports for our automated trading systems and I was reminded, yet again, how magical it is when a trading system gets in sync with its ideal market environment.

What stood out to me was the difference in trade frequency [aka portfolio turnover for you sophisticated types] across our trading systems and how that number impacts performance across varying market conditions. Keep reading to hear how you can use these insights to adapt your trading to the current market environment.

I recorded a video overview of everything in this article, so if you prefer to sit back, relax, and watch instead of reading, hit play below. We also have timestamps in the description of the video in case you want to jump around.

 

Classifying the market environment

Markets change their mood a lot. There are many ways you can classify the character of a market environment or an individual stock using trends, moving averages, breadth, etc., but for this exercise, we’re simply going to use volatility as our filter and focus on the S&P500.

When the VIX is low—let’s say, under 15—that suggests the market is pretty cool, calm, and collected and that it’s more than likely in an uptrend, or soon to be in one, if the low volatility persists.

However, when the VIX rises—let’s say, over 20—it means there are probably large price swings taking place, scary headlines, and investor emotions are running high.

This is a simple model for illustration purposes. Of course, there are outliers in each of those regimes, but given this very simple but powerful heuristic, we can orient our trading accordingly.
 

Defining your trade frequency

Picture Bob The Day Trader in your mind.

Bob sits down to trade the market open every morning, placing tens or even hundreds of trades in the fastest-moving hottest stocks of the day. Bob never holds positions overnight, so he needs to be prepared and ready to make money during the regular trading hours.

Image of Bob the Day Trader - Adapting your trade frequency to market volatility

Bob wakes up to crush markets with his favorite coffee mug.

Day trading is great because you always finish the day 100% in cash (and hopefully with more than you started!) and, therefore, never have any overnight risk to worry about.

What traders tend to overlook is that there are plenty of market environments where day traders like Bob, who are placing all those trades every day, are working so hard that they become counter-productive. They work against themselves and leave profits on the table.

I started off by mentioning that this blog post all stemmed from a performance review I was doing. So, here’s what I was looking at:

Trading System # of Closed Trades YTD Performance
Galahad 5 +25.13%
Merlin 60 +7.12%
Lamorak 117 +7.07%

Trade Risk’s trading systems invest up to 150% at times, see Performance Disclosures.

The numbers in this table were recorded on May 21, 2024 (year-to-date) returns, and the S&P500 throughout this period had an average volatility index $VIX of 14.15.

None of the trading systems are day trading systems, but I think you can still see the point I’m driving at.

Our least active trading system Galahad only made 5 trades in nearly 6 months and outperformed our short- and medium-term swing trading systems by a factor of 3.

Even though Merlin and Lamorak worked hard and turned over lots of trades, 10 times and 20 times the # of trades, moving from one opportunity to the next, they still couldn’t keep pace with Galahad the tortoise. Thankfully, all of this trading is fully automated, so I’m not the one glued to the screens pushing buttons.

Why was there so much outperformance? The long answer involves discussing a lot of factors, but the short concise answer circles back to the simple volatility regime we discussed earlier.

The market has averaged a 14.15 VIX year-to-date. That means things have been cool, calm, and collected, and when that’s happening, our lower-frequency trading system is maximizing its time in the market, sitting back and enjoying the ride higher.

Galahad is not trying to manage risk on every small pullback and rotate into different ideas. It’s sitting with winning positions and letting the prevailing trends carry them higher. More profits and less trading and screen-watching is our absolute favorite scenario — who doesn’t like working less and making more?

In a nutshell, you’re getting paid to stay more patient.
 

The more active your trading, the better you’ll do in volatile environments

We’re not here to bash on day trading because there are plenty of market regimes where I’d prefer to have a Bob in my portfolio that was intraday only, specifically during the high VIX regimes where panic and emotions are running high and holding overnight exposure doesn’t get rewarded.

High volatility means ranges are expanded, presenting lots of opportunities (and risks) in the market. The shorter your time frame and the more active you are (portfolio turnover), the more you can capitalize on the high emotions and abundant opportunities. Let’s revisit the performance of our same three trading systems throughout the bear market of 2022 when the average volatility index VIX was 25.59 for that calendar year.

Trading System Trade Horizon 2022 Performance
Galahad Long-term -14.53%
Merlin Medium-term -20.91%
Lamorak Short-term -6.29%

Trade Risk’s trading systems invest up to 150% at times, see Performance Disclosures.

 

We’re presented with the exact opposite results we looked at earlier. During a bear market and high volatility regime, our shortest frequency trading system performed best on a relative basis (everything was red). Note: these are all swing trading systems so nothing is truly short-term intraday, but you can see the correlation holds up with our volatility regime classification.
 

Aligning your trading pace with the market environment

There’s a lot more rigor we could apply to this type of analysis to truly isolate the return drivers of each trading system, but I wanted to intentionally keep things pretty high-level for this blog post. If you’re a discretionary trader that is dynamically trying to adapt to market environments and winning trade styles then I think this heuristic will steer you in the right direction.

Taking a pulse on the market environment and calibrating your trade frequency and intensity should serve you well. Micromanaging trades when the market is telling you the coast is clear (until it isn’t of course…) is inefficient and costs you time or profitability and, in the worst cases, both. On the flip side when fear really enters the market, it’s time to double down your sleep and wake up early so you can dial in and acutely manage risk and take advantage of the expanded ranges and fear in the marketplace.

For you systematic traders like us, this is once again a reminder of why we think it’s so important to diversify exposure across multiple trading systems. By trading multiple systems with different trade frequencies, we’re able to roll with the punches more evenly across changing market environments.

Have you come to similar conclusions with your trading? Leave a comment below and let us know your thoughts.

Enjoy what you read? Share it below and be sure to tag @thetraderisk.

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Evan Medeiros

Evan is the founder of the Trade Risk. With 25 years of coding experience and a B.S. in computer science, Evan brings a systematic discipline to investing in the stock market.

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