Trading Strategy Test

The following discussion summarizes the design and tracks the performance of an investment strategy that combines several potentially exploitable stock market premiums/anomalies. The purpose of the discussion and the test is educational, not advisory. Please see our disclaimer.

This test is entirely live (no backtest results) and out-of-sample with respect to all research.

We update this discussion as required based on activity, and monthly to record performance.

Test Strategy  -  Transactions -  Performance

TEST STRATEGY

The following figure summarizes the test strategy. It combines the following considerations:

Much research indicates that there is a size effect, with small capitalization stocks outperforming over the long term (see Blog Synthesis: The Size Effect). Much research indicates that there is a value effect (or, for rationalists, a value premium), with high book-to-market stocks outperforming over the long term (see Blog Synthesis: The Value Premium). Some research indicates that these two effects are interrelated. We seek to exploit both effects for enhanced long-term upward drift of selected equities. To obtain broad diversification and reasonable liquidity, we consider small-capitalization, value-oriented exchange-traded funds (ETF) in choosing a basic trading vehicle.

Some research indicates that there is a volatility premium, with the volatility priced into options higher than actual volatility (see Blog Synthesis: Equity Options). We seek to exploit this premium by repetitively selling near-term, near-the-money options covered by either stocks (call options against a long ETF position) or cash (put options on the target ETF). Generally, we expect to lean toward out-of-the-money options in an attempt to capture favorable price fluctuations in the underlying ETF.

Research indicates that the turn-of-the-month effect may be among the most reliable of stock market calendar anomalies (see Blog Synthesis: Calendar Effects and especially our blog entries of 7/20/06, 8/9/06, 8/24/06 and 4/5/07). We seek to exploit this anomaly by focusing on intervals several trading days before (after) ends of months to increase (decrease) market exposure via options as noted above. Option expiration dates generally fall near the interval before turns of months.

Some research indicates that valuation models such as our Real Earnings Yield (REY) model offer some utility in forecasting the intermediate-term performance of the overall stock market (see Blog Synthesis: Big Ideas for Investing/Trading and Blog Synthesis: Gunning for the Fed Model?). We seek to utilize the REY model as: (1) a weak indicator for possible adjustments in timing turn-of-the-month transactions; and, (2) a weak indicator for how far out of/into the money to go when selling options.

The test account is not tax-deferred. Tax impact is also a potentially overriding trading consideration. For example, when call options are about to expire in-the-money, automatic exercise may trigger a short-term or long-term capital gain/loss on the underlying ETF. Buying the option back before expiration in lieu of allowing exercise will depend on tax implications, as well as transaction costs.

The iShares S&P SmallCap 600/BARRA Value Index (IJS) and the iShares Russell 2000 Value Index Fund (IWN) are potential basic trading vehicles for the strategy. Both are small capitalization, value-oriented ETFs that offer broad diversification within category. However, IWN is more liquid than IJS. We therefore focus on IWN. Bid-ask spreads on this ETF and its options are relatively large. The option spreads may favor holding to expiration.

We will track the results for each transaction, but the principal test metrics are average monthly portfolio return and return standard deviation (in percentages) as compared to a buy-and-hold IWN benchmark, measured as of the close on each equity options expiration date.

General performance expectations are:

When the market rises (above the call options strike price at expiration):

• We either buy back expiring call options or keep the premium and let the market take the underlying fund shares. The overall ETF/calls position may underperform the ETF. Turn-of-the-month timing may mitigate underperformance by limiting the number of times call options expire in-the-money. REY model status may also mitigate underperformance by indicating adjustments to transaction timing and/or by suggesting how far out of/into the money to go when selling call options.
• We keep the premium on expiring put options, but the overall cash/puts position may underperform the ETF.
• A persistently rising market would tend to move the account into cash/selling puts, with attendant exposure to a "meltdown." REY model status may limit this exposure by suggesting how far out of/into the money to go when selling put options.

When the market falls (below the put options strike price at expiration):

• We keep the premium on expiring call options, and the overall ETF/calls position outperforms the ETF.
• We either buy back expiring put options or keep the premium and let the market assign the underlying fund shares. The overall cash/puts position outperforms the ETF. Turn-of-the-month timing may amplify outperformance by limiting the number of times put options expire in-the-money. REY model status may also amplify outperformance by indicating adjustments to transaction timing and/or by suggesting how far out of/into the money to go when selling put options.
• A persistently falling market would tend to move the account into the ETF/selling calls, precluding full participation in a "melt-up." REY model status may help mitigate this penalty by suggesting how far out of/into the money to go when selling call options.

When the market is approximately flat or modestly drifting (options expire out of the money):

• We keep the premium on expiring call options, and the overall ETF/calls position outperforms the ETF.
• We keep the premium on expiring put options, and the overall cash/puts position outperforms the ETF.
• A persistently flat market would tend to freeze the ETF/cash positions.

The studies supporting all the anomalies tested here use long-run analyses of historical data. The anomalies are all small compared to random fluctuation of prices, and there is disagreement about the significance and persistence of some of them. Portfolio construction in such studies is often complicated, and incorporating realistic trading costs is problematic. Awareness of the anomalies may well change investor behavior to counter them. Given all these doubts, a long-run test (years) is likely necessary to infer reliable results.

TRANSACTIONS

This strategy is effective as of the market close on 3/16/07. Transactions to date (recorded as executed) are:

3/23/07: Sell to open IWNPB puts expiring April 21, 2007 at strike price 80 (2% out of the money) against the account cash balance. [Expired out of the money.]

4/5/07: Sell to open IJWDZ calls expiring April 21, 2007 at strike price 78 (0.3% out of the money) against the account IJS holdings. [Expired in the money. Fund shares called away with strike price plus call premium below closing price.]

4/5/07: Sell to open IZZDE calls expiring April 21, 2007 at strike price 83 (1% out of the money) against the account IWN holdings. [Expired in the money. Fund shares called away with strike price plus call premium slightly below closing price.]

4/24/07: Sell to open IZZQE puts expiring May 18, 2007 at strike price 83 (0% out of the money) against the account cash balance. [Expired in the money. Fund shares delivered with strike price minus put premium below closing price.]

6/6/07: Sell to open IZZFF calls expiring 6/15/07 at strike price 84 (0.3% out of the money) against account IWN holdings. [Expired in the money. Fund shares called away with strike price plus call premium slightly below closing price.]

6/22/07: Sell to open IZZSE puts expiring July 21, 2007 at strike price 83 (0.1% out of the money) against the account cash balance. [Expired in the money. Fund shares delivered with strike price minus put premium slightly above closing price.]

8/8/07: Sell to open IWNKY calls expiring August 17, 2007 at strike price 77 (1.0% out of the money) against the account IWN holdings. [Expired out of the money.]

9/7/07: Sell to open IWNIW calls expiring September 21, 2007 at strike price 75 (0.2% in the money) against the account IWN holdings. [Expired in the money. Fund shares called away with strike price plus call premium below closing price.]

9/25/07: Sell to open IWNVY puts expiring October 19, 2007 at strike price 77 (0.6% in the money) against the account cash balance. [Expired in the money. Fund shares delivered with strike price minus put premium about equal to closing price.]

11/07: Elected not to sell call this month as the market dropped precipitously just before the selling window, and options expiration date was relatively early in the month. [If done, a sale of call options would have slightly trimmed the loss for the strategy, with options probably expiring out of the money. Without the sale, strategy returns differ just slightly from buy-and-hold due to a small amount of residual cash from past sales of options.]

12/7/07: Sell to open IWNLU calls expiring December 21, 2007 at strike price 73 (0.3% in the money) against the account IWN holdings. [Expired in the money. Fund shares called away with strike price plus call premium substantially above closing price.]

12/24/07: Sell to open IWNMV puts expiring January 18, 2008 at strike price 74 (0.1% out of the money) against the account cash balance. [Expired in the money. Fund shares delivered with strike price minus put premium much greater than closing price.]

2/7/08: Sell to open IWNBN calls expiring February 15, 2008 at strike price 66 (at the money) against the account IWN holdings. [Expired in the money. Fund shares called away with strike price plus call premium above closing price.]

2/22/08: Sell to open IWNON puts expiring March 21, 2008 at strike price 66 (at the money) against the account cash balance. [Expired in the money. Fund shares delivered with strike price minus put premium much less than closing price.]

4/4/08: Sell to open IWNDP calls expiring April 18, 2008 at strike price 68 (0.1% in the money) against the account IWN holdings. [Expired in the money. Fund shares called away with strike price plus call premium above closing price.]

4/23/08: Sell to open IWNQO puts expiring May 16, 2008 at strike price 67 (0.4% out of the money) against the account cash balance. [Expired out of the money.]

5/23/08: Sell to open IWNRQ puts expiring June 20, 2008 at strike price 69 (0.7% in the money) against the account cash balance. [Expired in the money. Fund shares delivered with strike price minus put premium less than closing price.]

7/8/08: Sell to open IWNGK calls expiring July 18, 2008 at strike price 63 (0.3% out of the money) against the account IWN holdings. [Expired in the money. Fund shares called away with strike price plus call premium plus dividend just above closing price.]

7/25/08: Sell to open IWNTN puts expiring August 15, 2008 at strike price 66 (0.5% out of the money) against the account cash balance. [Expired out of the money.]

8/22/08: Sell to open IWNUO puts expiring September 19, 2008 at strike price 69 (0.7% out of the money) against the account cash balance.

PERFORMANCE

The following chart compares the performance of the test strategy to date with that of the underlying IWN. After 17 months of testing, the average monthly return for the test strategy is +0.4%, compared to -0.4% for buying and holding IWN. The test strategy has beaten buy-and-hold in 13 of 17 months. The standard deviation of monthly returns for the strategy is 4.8% for the strategy, compared to 6.0% for buying and holding IWN. 17 months is not enough observations for reliable inference regarding long-term results.

The test strategy returns include all trading frictions, as well as dividends and interest on cash balances. In general, the test strategy has allowed shorted options to expire rather than bought them back to avoid the impacts of bid-ask spreads on closing purchases. The IWN buy-and-hold returns assume no trading fees but include dividends.

The next chart compares the cumulative value of hypothetical $100,000 initial investments in the test strategy, buying and holding IWN and buying and holding S&P Depository Receipts (SPY). It shows that IWN has underperformed SPY over the test period. In other words, the size/value premium has been negative over the test period to date. Some combination of the turn-of-the-month effect and the volatility premium (options selling) has apparently allowed the test strategy to offset the negative size/value premium.

See our blog entry of 7/18/08 for an interim review of the contributions of the value premium , size effect, turn-of-the-month effect and volatility premium to strategy performance.