Working Paper Article Version 1 This version is not peer-reviewed

A Linear Process Approach to Short-term Trading Using the VIX Index as a Sentiment Indicator

Version 1 : Received: 24 July 2021 / Approved: 29 July 2021 / Online: 29 July 2021 (16:24:34 CEST)

How to cite: Kobara, Y.M.; Pehlivanoglu, C.; Okigbo, O.J. A Linear Process Approach to Short-term Trading Using the VIX Index as a Sentiment Indicator. Preprints 2021, 2021070673 Kobara, Y.M.; Pehlivanoglu, C.; Okigbo, O.J. A Linear Process Approach to Short-term Trading Using the VIX Index as a Sentiment Indicator. Preprints 2021, 2021070673

Abstract

One of the key challenges of stock trading is the stock prices follow a random walk process, which is a special case of a stochastic process, and are highly sensitive to new information. A random walk process is difficult to predict in the short-term. Many linear process models that are being used to predict financial time series are structural models that provide an important decision boundary, albeit not adequately considering the correlation or causal effect of market sentiment on stock prices. This research seeks to increase the predictive capability of linear process models using the SPDR S\&P 500 ETF (SPY) and the CBOE Volatility (VIX) Index as a proxy for market sentiment. Three econometric models are considered to forecast SPY prices: (i) Auto-Regressive Integrated Moving Average (ARIMA), (ii) Generalized Auto Regressive Conditional Heteroskedasticity (GARCH), and (iii) Vector Autoregression (VAR). These models are integrated into two technical indicators, Bollinger Bands and Moving Average Convergence Divergence (MACD), focusing on forecast performance. The profitability of various algorithmic trading strategies is compared based on a combination of these two indicators. This research finds that linear process models that incorporate the VIX Index do not improve the performance of algorithmic trading strategies.

Keywords

Short-term trading; mean reversion; VIX; SPY; linear stochastic process; MACD; Bollinger Bands

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