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By Jesse
Although they may not be selling a strategy or investing concept to investors, they do have incentives to get their research published in academic journals that their peers may read and respect. There is also the financial incentive of job security by earning tenure at their university, for it’s“Publish or Perish” as the phrase goes. This means few, if any, are immune from the incentives to create an attractive looking backtest.
Does this mean we should dismiss all backtests? Certainly not, it just means we need a process, or series of scientific tests, that we run all our backtests through in order to keep ourselves out of trouble and from falling prey to good stories told by good salesmen. I must give credit where it’s due here. Both Dimensional Fund Advisors and the books and writings of Larry Swedroe have influenced my thinking when it comes to this topic. For those who want to go deeper, I recommend reading Larry Swedroe’s book, “Your Complete Guide to Factor-Based Investing.”
The 5 characteristics to look and test for when considering investments are:
Persistent across time. The strategy or factor can be tested on long periods of historical data to increase statistical confidence. Larry Swedroe often points out that the average investor thinks three years is a long time, five years is a really long time, and 10 years is an eternity...yet if you ask academics, they will tell you that 10 years is nothing more than random noise that likely should be ignored. For example, the S&P 500 returned -1% per year from 2000-2009. Would that have been a good indication of long term expected returns for buying large cap US stocks? Since then, the S&P 500 has compounded at more than 12% per year, which is better than its long-term average. This is similar to how in August of 1979 BusinessWeek wrote a cover story called “The Death of Equities” after the S&P 500 had experienced a similarly long period of poor performance. The S&P 500 went on to compound at more than 17.5% annualized for the next two decades, turning $100,000 into more than $2.6 million.
Pervasive across markets and geographies. The strategy or factor holds up when tested on other markets and countries. For example, the momentum effect has been found to exist in stocks, bonds, commodities and currencies. It’s also pervasive across sectors and in the historical data of nearly every country.
Robust to various definitions. An effect should still show up when constructed with similar parameters. For example, the value effect is both persistent and pervasive as well as robust to alternative specifications. Whether it's price to book, price to sales, price to earnings, price to dividends, price to just about anything...you find in the historical data that value stocks (low price relative to fundamental measurements) outperform growth stocks (high price relative to fundamental measurements) over the long term all across the world.
Investable. The strategy exists not just on paper but survives real world issues such as manager fees and realistic assumptions for transaction costs. Many anomalies discovered in the historical data persist simply because they are difficult to implement at size in the real world. Academics refer to this as "limits to arbitrage,” where an anomaly persists in the data because it's difficult or impossible to actually implement at scale and therefore it’s really only a paper illusion.
Intuitive. Does the strategy make intuitive sense with (preferably) a simple risk-based explanation or,at minimum, a logical behavioral based explanation? For example, the market factor (stocks producing higher returns than T-bills) has persisted for decades even though it's as "well known" as any factor there is. Since everybody knows about it, why doesn't it get arbitraged away? One rational answer is that you simply cannot arbitrage away risk. Not only do stocks occasionally underperform cash over 3, 5, and 10-year periods, they can do so by A LOT (S&P 500 example in #1). The same is true of all other academically accepted factors like size, value and momentum. For this reason, investors who have a sufficient time horizon and temperament can consider tilting their portfolio towards these "open secrets" that have a long history of producing higher than market returns. Now, which factors pass all five of these tests and therefore are eligible for inclusion in our client portfolios?
The market factor (stocks have higher expected returns than cash and bonds). Risk based explanation. The term factor (bonds with longer maturities have higher expected returns than bonds with shorter maturities). Risk based explanation. The size factor (small caps have higher expected returns than large caps). Risk based explanation. The value factor (value stocks have higher expected returns than growth stocks). Both risk and behavioral based explanations. The trend/momentum factor (stocks and asset classes that have outperformed over the last 6-12 months have near term higher expected returns than stocks and asset classes that have underperformed). Behavioral based explanation. The volatility risk premium factor (also known as the insurance risk premium…selling financial insurance in the form of puts and calls has positive expected returns). Risk based explanation.
Conclusion
When investors understand the concepts discussed in this article, your investing life will never be the same. Using this checklist dramatically improves the odds of success and can keep investors from falling prey to a good sales pitch or chasing a good looking backtest that is unlikely to persist going forward in time on a net of all costs basis (transaction costs, manager fees, and taxes).
The real opportunity now becomes the portfolio construction process. We know that the pursuit of traditional active management is largely a waste of time and money, because any manager or backtest performance can be largely explained by exposure to these well-known factors that can now be accessed at low or at least fair costs. These factors discussed have low correlations to one another, so diversifying broadly across them dramatically reduces the risk of your total portfolio. So much so that modest amounts of leverage may be appropriate for those with the patience and perspective to seek higher expected returns.
The biggest risk of a portfolio diversified by factors becomes more behavioral, where your portfolio will at times perform far differently than conventional market benchmarks that are only exposed to the single factor of market beta. Since the only purpose of investing should be to achieve your long-term goals with the least risk, this should be an acceptable trade-off for a well-educated and well-behaved investor.
Jesse Blom is a licensed investment advisor and Vice President of Lorintine Capital, LP. He provides investment advice to clients all over the United States and around the world. Jesse has been in financial services since 2008 and is a CERTIFIED FINANCIAL PLANNER™ professional. Working with a CFP® professional represents the highest standard of financial planning advice. Jesse has a Bachelor of Science in Finance from Oral Roberts University. Jesse manages the Steady Momentum service, and regularly incorporates options into client portfolios.
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By Reel Ken
The Theory is pretty easy to understand. It is backed up by mounds of statistical proofs and observations. Advanced math skills are not necessary. It is really borne out of two separate but interrelated concepts … 1) Market Performance and 2) Individual Performance. Let’s take a look at these two elements:
Market Performance:
A statistical proof exists; separate from data collection or observation, that indicates the market should have an upward bias (or positive skew). Observations and data, collected over the last 100 years confirm this to be true. It is noteworthy that the data confirms the theory and not the other way around. One doesn’t need a statistics degree to confirm this … they need only look at any long term chart and they can easily see that the market is an ever upward climb.
Of course it has it “fits and spurts” but the upward bias is obvious to all that take the time to look.Though there is some discussion of how large this skew is, most studies indicate that the market is up 60% to 70% of the time. This seems to hold true when viewed over decades, years, month, weeks and even days.
Individual Performance
This is a little bit trickier to explain … but I’ll do my best. First, we must differentiate between the “trader”, the “market timer” and the long term investor. There have been many studies of professional money managers and individual investors that differ somewhat in their quantitative results but agree in the overall result … most investors (pros and DIY) underperform a simple buy and hold of abroad market index. Furthermore, this underperformance is not small … in some studies is as much as 5% per year in the short term, and even more in the long term
Time Period (ending Dec. 31, 2014)
Average Equity Fund Investor Return
S&P 500 Average Return
5 years
10.19%
15.45%
10 years
5.26%
7.67%
20 years
5.19%
9.85%
30 years
3.79%
11.06%
Simply put: The most effective investment strategy is “buy and hold” but few actually accomplish this end. The reason seems to be pretty simple … the average investor is driven “emotionally” not logically.Every seasoned investor has experienced this ... or they are kidding themselves. No one … yes, no one … is immune.
Additionally, asset allocations such as the most popular 60%/40% stocks/bonds are widely recommended. Contrary to this, the data indicates that the most effective allocation is actually 100% stocks. By example, if we took the Five Year results from the above chart we would have a 10% Equity return. But if one was, say 60% in stocks, the equity return as a percentage of their portfolio is closer to 6%. So, on a portfolio basis they are not achieving anywhere near the 10% return. Contrast that with over 15% had they just simply put all their assets into an index fund and not engaged in any trading activity.
Of course, very few investors will accept this because of the risk of loss in down years (we all remember 2008). But, once again, the path is clear … it is the emotional courage that is at issue. Even the worst of down years are regained in a couple of years. Nonetheless, investors seem willing to accept less than optimal returns in exchange for some degree of safety.
Calendar Option Theory
Let me be emphatic that this conversation is about utilizing calendar spreads as an adjunct to or as a core position. It is not targeting “one-off” trades”. That’s for another day.
So, this brings us full circle to the theory behind calendar spreads (and most hedges, for that matter). Investors should seek out ways to be fully invested and also limit their downside risk. The theory is based, mostly, upon the fact that most investors would have increased PORTFOLIO returns if they abandoned traditional asset allocation mixes (such as 60%/40%) and, instead put 100% of their portfolio in an index fund and bought a far dated put to protect the downside.
It is so with calendar spreads. One can expand their allocation towards equities, and away from bonds, while protecting against loss.
Of course, the far dated put detracts from returns, but the ability to be 100% equity invested, the ability to have a cap on the downside (usually less than 5%/year) will enable the investor to outperform traditional asset allocations and … most importantly … enable them to avoid panic and emotional selling.
Now, with this theory behind us, let’s look at calendar spread methodology.
Methodology
First the time to employ a calendar spread is during a rising market (or at least a flat market) when volatility is average or lower. This is common sense. The far-darted long put wants to be bought at the most economical price and lower volatility lowers the cost. Not rocket science.
Next, and the more difficult part, is the setting of the near--dated put-write. This is complicated because one needs to consider the strike; the expiry; and when to roll. So let me give some guidelines.
Strike
One can “play around” and try to guess the market and go ITM, ATM or OTM as they please. My personal experience and the rather dismal track record for “market timers” would discourage this in favor of a more systematic approach. This approach would be based upon the concept that the market has upward skew. It is also aided by the fact that the downside is limited and protected by virtue of the long, far dated put.
That being the case, the put-write strike should be as deep ITM as practical. Simply stated, it replaces a long equity position. The further ITM it is placed, the closer it comes to mimicking a long equity position.
Remember: One sells a near-dated put instead of an outright buy of the underlying, to try to capture extrinsic with the hopes that it will offset the cost of the far-dated.
There aren’t a lot of studies that would indicate how DITM it should be set, but if done as a monthly strike, 2% seems to be confirmed in at least one study. But before someone hops on that, we need to look at what is the best expiry.
Expiry:
When one sells a DITM put, it favors selling shorter durations provided the move --- in the direction of the strike --- does not exceed TWICE the premium collected. This is true whether one is comparing a weekly to a two-week; a weekly to a monthly; or a monthly to a quarterly; or even a weekly to a leap. So, if one sold a near-term put and received, say, $5 in premium … the near term is favored over any far-dated, provided the underlying doesn’t rise more than twice ($10) the premium received.
Strike and Expiry
Unfortunately, this is sort of a balancing act and there is no definitive study that helps us out. Combining the two elements, my experience is that selling a weekly 1% ITM is the right level. However, that holds only on an underlying with a Beta of 1 (SPX). If the underlying Beta is, say, 1.5, then the strike should be 1.5% ITM …and so on.
The 1% ITM shows gains in and of itself and compared to a further-dated as long as the weekly move is less than 2% up. Now, there will be times that the move is greater than 2%up. This will happen, on average, 4 times a year. But the frequency of large up moves may be offset by “Holding the Strike”.
Holding the Strike
This is the most important part of selling puts (calendar spreads or naked puts). If there is a drop, do NOT lower the strike and try to capture more extrinsic. Always be willing to sacrifice extrinsic on a down move in order to be prepared for the inevitable bounce back up. It may come in a week; a month; or a year. But the market, historically and scientifically has always (yes, ALWAYS) rebounded.
The real danger to a calendar spread is losing short term value on a big move down and then not fully regaining it on a bounce (the “whip-saw”) Always keep in mind that the far-dated protects the downside … “holding the strike” protects against the “whip-saw”.
Additionally, many times a big up move will follow a down move. So, holding the strike will reduce the frequency of being over-run.
Combining these three ingredients, one should sell the short put on a weekly basis; the greater of 1% ITM or the previous strike.
Rolling the PUT
As long as the PUT is ITM, it is best to hold till expiry to maximize theta decay.
However there will be times when one sets the strike 1% ITM on Friday and on Monday the market moves up 1%. What to do? Will the market drop by week’s end? Or, will it continue up?
There is no answer. The market will do what the market will do. History tells us that it is 60-40 going to go up. That may be sufficient reason to raise the strike. Even if the strike holds, you would have raised it another 1% on expiry under a normal roll, so at worst, you’re doing it a little early. Rolling up ½% now would be a cautious minimum.
A greater dilemma occurs if the move is greater than 1% early in the week and you’re now OTM. If a strike is over-run and then rolled up, you incur a permanent loss of some amount. However, I’d consider rolling up on the basis that even if there is a drop down, theprevious level will be regained.
Knee-Jerk or Fundamental
With all that said it is worthwhile to evaluate the character of any big move. Is it knee-jerk or fundamental? Has something changed or is it concern over the possibility that something may change? Every investor needs to consider these factors. If there is a fundamental deterioration in the economy, then one might want to be somewhat more defensive on the near-term put-write. My best advice is to make any such determination carefully and don’t be afraid of getting there a little late. The far-dated put protects. So it is never an issue of suffering large losses, it is more about possibly making money during the bear, while others lose money.
Summary
Calendar spreads bring with them problems that all investors must face … what to do? These guidelines can resolve what to do on a down move… Hold The Strike. What is so simple in a calendar spread is usually the most difficult decision investors using traditional methods face.
These guidelines also resolve what to do on more modest moves (less than 1%/week). Stay the course.
Over-runs are more problematic. They resemble the issues that traditional investors face on up moves. Is it going further or is it coming down? The only way to fully resolve this is to make a determination as to whether it is a knee jerk or fundamental move.
However, absent clear signals that a fundamental change has taken place … be willing to err by adjusting on the side of the market going up, even more.
Ken Reel is a well known and respected Seeking Alpha Contributor with over 100 articles. He has worked in the financial service industry for 40 years. Ken's area of expertise is risk management and complex financial products. He has been a frequent speaker, on behalf of many financial firms, to financial professionals across the country. He has extensive experience in statistics and actuarial science.
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By Kim
The following article described few stocks that we use over and over again, cycle after cycle. We said "$TSLA, $LNKD, $NFLX, $GOOG: Thank You, See You Next Cycle".
Well, the Next Cycle is already here.
NFLX is one of those stocks. Here are our results from NFLX in the recent cycles:
+10%, +20%, +30%, +16%, +30%, +32%, +18%
Another earnings cycle has arrived, and NFLX delivered another nice winner for us. We opened a pre-earnings calendar at average price of $3.50 and exited at average price of $4.55, booking a 30% gain in the process. That marks eighth consecutive NFLX winner in the last few cycles.
But some of our members did even better. Here is a screenshot from the forum:
This member booked 47% gain! Here is another one:
And one more:
Those are real fills from real members. Not hypothetical returns. REAL RETURNS FROM REAL TRADERS.
Those returns are even more remarkable when you consider the fact that the stock moved 15%+ in the last few days. We played it non-directionally, so we didn't really care which direction it will move, but booking 30-50% gains on a non-directional strategy after such a move is truly amazing.
Earnings season is just starting. We are planning to play GOOG, FFIV, CMG, FB, AMZN, MSFT, BABA, LNKD, TSLA and more. Each stock has its own "character", the best time to enter and its unique setup.
We already booked 57.6% ROI since the beginning of 2015. We can help you. If you want to learn those profitable options strategies:
Start Your Free Trial
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By Kim
Our long term members know that we like to use few non-directional strategies to play earnings. There are few things we like about those strategies:
They are predictable. They are repeatable. They are flexible. They can be used on the same stocks cycle after cycle. The following article described few stocks that we use over and over again, cycle after cycle. We said "$TSLA, $LNKD, $NFLX, $GOOG: Thank You, See You Next Cycle".Well, the Next Cycle is already here.
Click here to view the article
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By Kim
Our long term followers know that buying premium into earnings is one of our favorite strategies. I wrote about the strategy in my Seeking Alpha article Exploiting Earnings Associated Rising Volatility. IV (Implied Volatility) usually increases sharply a few days before earnings, and the increase should compensate for the negative theta. We have been using this strategy in our SteadyOptions model portfolio with great success.
However, not all stocks are suitable for that strategy. Some stocks experience consistent pattern of losses when buying premium before earnings. For those stocks we are using some alternative strategies like calendars.
Click here to view the article
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By tjlocke99
Hello. I have a few questions/comments about backtesting in TOS.
1. If you select that you entered a trade in TOS using the thinkback tool, is the price you enter supposed to be based on the opening price for legs in the options spread for that day?
2. When you close the trade does thinkback assume you are getting the mid of closing price for the legs in the options spread that date?
3. Is it the closing price for the underlying that day?
I always assumed it was based on closing prices, but I just wanted to check.
Also, I see this as a major issue with backtesting in TOS, you can only base it on whatever open/close condition it uses.
Thank you!
Richard
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By tjlocke99
I keep thinking I am missing something but I think TOS thinkback may have some major defects.
Take a look at ABT (Abbott Labs) "Last" price on 7/10/2012: 65.67
Then TOS thinkback says for 7/11/12 "Last" 65.18, Net Chng, +.02
This VERY wrong. 65.67 to 65.18 represents a decrease in price NOT a +.02.
Am I missing something?
Thanks!
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