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February 20, 2009
I have considered many various investing strategies over the years for my personal portfolio. The bulk of the investments I have done have focused on arbitrage conditions or leveraged option strategies. However, with stock market upheaval in October 2008, the leveraged strategies caused a major loss to my more at risk investments. I don't feel content, however, to accept regular returns. This blog will illustrate one strategy which should always outperform the S&P500, making only one trade per month. It is being initiated today because trading will usually occur on the 3rd Friday of every month (option expiry day).
The simple strategy was developed by looking at the history of the exchange traded fund (SPY). SPY is a fund that seeks to perform in line with the S&P500, and does a very good job at it. plot the S&P500 index (^GSPC) with SPY and the lines are exactly on top of each other since its inception. So, in general, investing in this one stock is one of the simplest, most diversified, least expensive ways to invest. It will outperform 85% of mutual funds, and be less volatile than most. However, having said that, we can do better. When looking at the history stock price, SPY never gains more than 10% in a given month (max to date is 9.4%. So, if our investment strategy employs options with strikes greater than 10% above the current market price, there is virtually no chance the option will be called out. With odds like that, you don't have to risk much to make good money.
Calculating month over month is not completely accurate given that options expire on the third Friday of each month, not the end of the month, so using month over month calculations is offset by one week, but if we assume the market does not care about options expiry day, then this set should be as good as a set presenting values from the third Friday of each month. However, to calculate our maximum risk, I took weekly historical prices and looked at moves over weeks (rolling).
| TABLE: Maximum and Minimum
returns generated from rolling calculations |
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|
|
1 Wk |
2 Wks |
3 Wks |
4 Wks |
5 Wks |
6 Wks |
7 Wks |
8 Wks |
| Max Gain |
13.29% |
10.58% |
12.56% |
15.82% |
14.91% |
18.36% |
21.28% |
20.14% |
| Max Loss |
-19.79% |
-26.77% |
-28.70% |
-29.81% |
-29.87% |
-31.28% |
-31.74% |
-34.20% |
All of the maximum losses in this chart occurred in October 2008. If calculations are made using only data through Aug 2008, the data is as follows
| TABLE: Maximum and Minimum
returns generated from rolling calculations through Aug 2008 |
|
1 Wk |
2 Wks |
3 Wks |
4 Wks |
5 Wks |
6 Wks |
7 Wks |
8 Wks |
| Max Gain |
7.58% |
10.23% |
12.56% |
15.82% |
14.91% |
18.36% |
21.28% |
20.14% |
| Max Loss |
-10.52% |
-14.78% |
-18.27% |
-16.68% |
-18.45% |
-20.22% |
-20.99% |
-22.06% |
The frequency at which certain price movement levels are achieved is shown in the following table. These numbers are derived from rolling periods, and so reflect the maximum potential frequencies that can be expected. The true expected frequency for sequential time periods would be the values below divided by the number of weeks in the period, rendering the probabilities quite infrequent.
| TABLE: Number of times
percent values are achieved in rolling periods |
|
|
|
1 Wk |
2 Wks |
3 Wks |
4 Wks |
5 Wks |
6 Wks |
7 Wks |
8 Wks |
| n above
20 |
0 |
0 |
0 |
0 |
0 |
0 |
1 |
1 |
| n above
15 |
0 |
0 |
0 |
2 |
0 |
3 |
6 |
4 |
| n
above 10 |
2 |
2 |
8 |
9 |
9 |
12 |
17 |
16 |
| n below
10 |
3 |
5 |
7 |
11 |
10 |
11 |
10 |
12 |
| n below
15 |
1 |
2 |
3 |
2 |
3 |
3 |
6 |
5 |
| n below
20 |
0 |
1 |
1 |
1 |
1 |
2 |
2 |
2 |
| n below
25 |
0 |
1 |
1 |
2 |
1 |
1 |
2 |
2 |
| n below
30 |
0 |
0 |
0 |
0 |
0 |
2 |
2 |
3 |
| Total
weeks: |
833 |
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|
|
|
|
|
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All of the prior illustrations only serve to indicate that this technique has a high success rate. The vast majority of the time, you will succeed. However, this does not mean much if the return is negligible. The value of any trading strategy is the a function of its return over time. The higher the average return per trade and the higher the probability of success in the trade the the better off you are (probably). The entire stock market is simply a game of statistical probabilities, and to the investor that does not have the capacity to do much of their own research, it is entirely a game.
So, based on the prior information, there are many ways that an investor can outperform the S&P500. These include:
Purchase the stock SPY and sell a covered call every month (generally on the third Friday of the month) with a strike price 10% above the current price. - This is the most conservative strategy. The sell of the call is protected by stock and generates revenue, but the person also experiences the capital growth of the stock. There are always two risks to a covered call. First, the stock value may go down. Your sale of the covered call helps to cover some of the loss, but you can still lose. The second risk in a covered call is missed opportunity in the growth of the stock. Selling a covered call close the the current stock value yields better covered call returns, but it the stock moves rapidly you lose in the stock growth. This is OK if you are trading many different stocks, because you can just go to another stock to do your next trade if you are called out of the one stock. it is not so good if you are continually trading the same stock, because you can end up repurchasing your stock back every month at a higher price if it continues to rise, a counter productive measure. However, in this strategy, getting called out of the stock will almost never happen, and if it does, it is only because the stock has already moved greater than 10% in your favor in the last month anyway. Your reward for doing this varies by implied volatility. Based on today's (February 20th 2009) option prices and volatility, the annual return on selling the call alone is 10 to 12% per anum. Also add in the 3.5% annualized quarterly dividend paid by SPY, and this strategy will always outperform the S&P500 (and predictably by double). To track the performance of this strategy, see the performance blog: Always outperform the S&P500: Covered Call blog
Sell a naked call at 10% above the current SPY price every month (generally on the third Friday of the month) . - This strategy yields a much higher return than the covered call but yields substantial risk if the stock moves at an unprecedented rate one month. Because of the risk, this type of trade requires considerably more margin than a standard vertical spread and is therefore usually not done in favor of using a vertical bear call spread.
Sell a vertical bear call spread with the sold leg strike at 10% above the current SPY price every month (generally on the third Friday of the month) . - This strategy in absolute cash received each month yields less than the naked call, but because of the higher margin requirements for the naked call, the spread yields a better return. It also has the advantage of having less risk. Returns range between 8 and 12% per month, but the risk is that if a spread yield is 12%, then if you are wrong, you will lose 88% of the money you have invested. Not a big deal given the low probability of the stock achieving this level, but absolutely should not be done by someone who is relatively new to options. You will eventually lose with this strategy and if your money is not properly managed, you can lose it all. It is probably best coupled as a supplementary trade to a covered call trade.
Sell a double vertical spread (composed of a bear call spread and a bull put spread) with the sold call leg strike at 10% above the current SPY price and the sold put leg strike at 10 to 15% below the current SPY price every month (generally on the third Friday of the month) . - This strategy will yield twice the monthly return as the just the vertical bear call spread for effectively the same margin risk. This is because only one spread can ever go against you at a time. It is simply not possible to bet called out on both at the same time. The disadvantage is that it exposes the investor to the losses if the stock falls precipitously and stocks fall faster than they can rise. Therefore you will increase the frequency at which the trade will go against you, but if that can be offset by the increased returns, then that is not a problem.
Each of these strategies as well as variations on each are detailed in the following pages:
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