Feeling Trapped

The recent snap back from the recent panic move down has been very unsatisfying. I did make some long term buys during the pullback, but I did not make a large commitment. The lack of a written plan leaves me with doubts as to what I should have done. I feel trapped by the market no matter what it does. A comprehensive business plan would reduce such feelings. But why am I resistent to creating such a plan? There is nothing stopping me (or you).

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The fourth Patriarch was Tao-hsin who attained his own liberation in a famous dialogue. He came to Seng-t'san and asked,
   "What is the method of liberation?"
   "Who binds you?" asked Seng-t'san.
   "No one binds me." said the pupil.
   "Why then", said the master, "do you seek liberation?"
That was enough for Tao-hsin, who in that moment 'saw'.

-- From "Zen a way of life", by Christmas Humphreys

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Excessive Option Profits Revisited

Revisiting index put option selling as mentioned in my 'Caviar Breakfast Everyday' post... The plot above shows the risk profile for 10 October 48 puts on the QQQQs sold naked short. The 48 strike is about 5% out of the money and at the end of the day Friday could be sold for about $0.39. The sale brings in about 5% of the initial margin required so we may make up to about 5% if the options expire out of the money. That is a reasonably good return for one month.

The risk profile shows the profit/loss at various QQQQs prices at expiration (green line) and two weeks prior to expiration (white line). The highlighted area shows the one standard deviation range for the price. As long as the QQQQs only move one standard deviation against us by expiration, we make the maximum profit of $390. If the QQQQs move two standard deviations against us we lose about $1200. If the QQQQs move one standard deviation against us by two weeks prior to expiration, we have an open loss of about $340. The open loss prior to expiration requires us to put up more margin.

We have the potential for substantial profits most of the time. The options in this example will expire value-free about 87% of the time and we will make our maximum profit. The problem is to determine how bad the loses can be. Certainly most of the time all is well, but the price statistics are not normally distributed and disasters will occur more frequently than the normal distribution suggests. However, we are being well compensated for the disasters by the high price of the options.

How do we deal with the occasional disaster? We can just proceed and limit the leverage to avoid being wiped out. We can switch to selling credit spreads to cap our losses in the event of a disaster. We can use market timing to limit out naked selling to periods in which we believe disasters will be less likely. Using credit spreads and/or market timing will limit our profits to some extent.

In summary, I have not reached a conclusion as to whether or not naked index put selling is right for me. I will continue to investigate this approach further. What is your conclusion?

The Fed: Smell of Napalm At 2:15

There you have it... the Fed called in a napalm strike this afternoon. The internals were very strong. The number of 20 day highs spiked up to levels not seen since April. (See the plot above.) The number of 20 day lows remains a bit elevated.

If no disaster is revealed in the next few days we could see the SPY at new highs. The big money seems to have commanded a return to 'unstoppable move up' mode.

The Fed - Which Goblet Contains the Poison?

The scene from "The Princess Bride" in which the dread pirate Roberts challenges the criminal genius Vizzini to a battle of wits clearly illustrates the problems many people get themselves into concerning the Fed's actions. In the scene, Roberts takes the two goblets of wine and adds poison. He then challenges Vizzini to determine which goblet contains the poison. After Vizzini selects, they will then both drink and one will be right and one will be dead. Vizzini considering seemingly all of the possibilities selects the goblet from which he will drink. He also delights in demonstrating his extreme cleverness to Roberts.

The selection process is the same sort of nonsense that occurs prior to each Fed meeting. A post by CXO Advisory shows that during the period around Fed funds rate changes there is no real bias to exploit anyway. The seeming endless speculation on whether the Fed will or will not drop rates by an amount or whether this is fully priced into the market is just a distraction.

At the end of the scene Vizzini dies and we find out that Roberts has poisoned both goblets of wine. He has spent the last few years developing a resistance to the poison so he survives. This illustrates what we should be doing. We should focus on our research, diversification, and position sizing not demonstrating our cleverness in determining the direction of a short term trade that has no edge.

Caviar Breakfast Every Day

The CXO Advisory Blog has a very interesting post on selling index put options. I may have been too quick to dismiss index option selling as too risky. The premiums that the buyers are willing to pay are irrationally high. "For buyers of at-the-money puts to break even, October 1987-like crashes would have to occur 1.3 times per year."

I will be investigating this further. Perhaps if you limit your leverage to reasonable levels, you may be able to confine the drawdowns to something that you can live with.

Intermediate Term Outlook

Is it possible to extend the idea of examining short term patterns (number of days up/down, percent up/down, etc.) to determine short term direction to a longer time frame? In the plot above the blue line is the closing price of SPY. The green portion is the most recent 65 days of the SPY price data. The red line is the correlation of the most recent price data to the past price data. The plot only shows when the correlation is reasonably high.

The high correlation zones from 2003 to 2007 were good buying opportunities. However, the high correlation zones from 2000 to 2002 were good selling opportunities. This leaves us with no conclusion unless we already have an opinion about the big picture direction of the market. The longer time frame also means that we do not have a significant number of instances from which to make a decision.

Your Personal Legend

Dr. Brett's excellent post, "When the Trading Dream Dies", captures the Mediocre Trader mindset. After you abandon the big league dream (or more likely the big league fantasy) you will be free to create and pursue a new dream.

Free yourself so you can begin to work on realizing your Personal Legend ("The Alchemist" by Paulo Coelho).

Take a look at the Crazy Sexy Cancer website for some additional perspective.

My name in Inigo Montoya, you killed my father, prepare to die.

Sector Rotation

What about using a simple sector rotation scheme to substitute for SP-500 exposure? The first plot above shows a comparison of such a scheme compared with SPY. The sector rotation did much better during the down market of 2000 to 2002 and did better during the up market of 2003 to 2007.

The results shown are based on the relative strength of the nine Select Sector SPDRs (XLB, XLE, XLF, XLI, XLK, XLP, XLU, XLV, XLY). The bottom three sectors based on 30 day relative strength are purchased and held for 30 days. The results for the top three sectors are much worse in the down market of 2000 to 2002 and a not quite as good as the bottom sectors in the up market of 2003 to 2007.

The relative strength approach is sensitive to the start time of the testing. The second plot above shows the results for the sector rotation with different starting times. All of the starting times produced better results than just holding SPY.

Sector rotation looks promising as a way to increase a portfolio's return without taking on much additional risk. Additional investigation is necessary. For example, most of the transaction costs can be eliminated if we use a single mutual fund or ETF. The Claymore/Zacks Sector Rotation ETF (XRO) and the Rydex Sector Rotation Fund (RYSRX) are available. XRO only has one year of data available and RYSRX only has data from 2002 so we cannot tell if they would have held up as well as the bottom three SPDRs scheme in a significant down market.

I will continue to investigate and provide additional updates on sector rotation in the future. Does anyone know of other sector rotation ETFs or mutual funds?

A Player...or Nothing

Wake up, will ya, pal?
If you're not inside, you are outside, OK?
I'm not talking about some $400,000-a-year Wall Street stiff...
...flying first class and being comfortable. I'm talking about liquid.
Rich enough to have your own jet.
Rich enough not to waste time.
Fifty, a hundred million dollars, Buddy.
A player...
...or nothing.


While it may be amusing to think about being a player, everyone cannot be a player. This is especially true for the part time trader. But.. there is an alternative to the nothing that GG mentions above. You can be a Mediocre Trader!

The Mediocre Trader has the interest, research capabilities, discipline, and resources to be far more successful than the uninformed trader. The Mediocre Trader also has a sense of his place in the food chain so that the disasters common to the uninformed trader can be avoided. And if things work out as a Mediocre Trader, you can always become a player later.

So let's become a Mediocre Trader!