A world-champion quant trader with a 491% gain shares a strategy with a 75% win ratio and 3-to-1 profit potential

• Stock market volatility may be elevated as we enter the first year after an election.
• Ivan Scherman, a hedge fund manager, uses mechanical trading to leverage market volatility.
• One recommended strategy involves S&P 500 and VIX divergence, with a 75.3% win ratio from backtests.

The first year after an election tends to bring elevated volatility for the stock market, says Ivan Scherman, a chartered market technician and hedge fund manager.

And if the incoming Trump administration implements more extreme policy changes, that may kick that volatility up a notch. But it's not a bad thing if you're a trader because you can take advantage of the peaks and valleys, said Scherman, who won the 2023 World Cup Trading Championship for futures with a 491.4% return.

"That's not something you have to fear," Scherman said. "But you need to wait for the proper time in order to take advantage of the conditions that the volatility is going to give you."

As a quant fund manager, he has backtested thousands of models before putting hundreds of them to work while he monitors their progress. Using a machine to make trades means he can diversify bets across everything from the S&P 500 to coffee and even soybeans.

But perhaps one of the most important advantages of a mechanical approach is that it allows him to set his emotions aside: a shift that every successful trader eventually realizes is key to survival because it prevents rash decisions.

While not everyone has the ability to backtest and build quant models, there are mechanical trades that can be executed manually. In a volatile market, Scherman likes a pattern that spots a divergence between the S&P 500 and the CBOE Volatility Index (VIX), which is used to measure expected volatility.

The pattern, which has been backtested from 1957 to date, showed the strategy had a win ratio of 75.3% and a profit factor of 3.16, which means for every dollar you lose, you can make $3.16, Scherman noted. Despite its long track record of success, past behavior does not guarantee future outcomes.

"You have no guarantee that this is going to keep happening in the future, of course," Scherman said. "But I think it's a very stable pattern because it responds to one of the internals of the market, which is the put-buying that institutions use in order to hedge their positions. If they are not buying puts, they're not hedging their positions."

I used this strategy from 2006 to 2018, both for me and for the fund I work for. I personally traded with the e-mini S&P 500. For the fund, I traded it by using SPY and SPXL.

Scherman told Business Insider he traded this pattern both for his personal account and hedge fund with very good outcomes but isn't authorized to disclose performance metrics due to compliance. Today, his fund trades an improved version of the trade that can't be disclosed to maintain competitive advantages.

Below is a chart that shows the profit potential of repeating the trade over time pulled from the backtest.

A mechanical trade

The setup requires the S&P 500 and the VIX set up on the same chart. The notion then follows that when the S&P 500 experiences a correction, signaled by a drop in price, the VIX should spike in correlation to that dip, as a likely sign that institutional investors are buying puts as a hedge against the correction.

When the first correction is followed by a second dip in the S&P 500 in the form of a lower low than the first, the VIX should also see a second spike in correlation. However, the VIX should technically see a higher high. But if the second VIX spike isn't higher than its prior spike, this slight discrepancy is what Scherman calls the divergence.

He said that the pattern is provoked by big institutions that don't believe that the S&P 500 is in a steeper correction, so they won't hedge by buying further puts, causing a more muted spike in the VIX.

The second required condition is that the S&P 500's price movements should not be farther out than two standard deviations from the 30-day moving average, a range that can be set using Bollinger bands. If the index's price swings fall outside the Bollinger band, in this instance below it, the trade should not be taken, Scherman noted.

If all conditions are met, the trader should buy the S&P 500 at the close of the stock market day.

Below is a chart demonstrating the S&P 500 in correlation to the VIX.

The exit strategy

Once in the trade, there are two exits. The first is the winning one, which happens if the S&P 500 goes above the 30-day moving average. Once this condition is met, the trader must exit the trade at the close of the day.

The second exit would be a loss and would be executed if the S&P 500 is set to close two standard deviations below its 30-day moving average, thus outside the Bollinger band. Here, a trader must cut their losses and accept that the thesis failed. Scherman noted this will happen around 25% of the time based on the backtest.