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 research.

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

Original Test Strategy – Revised Test Strategy – Transactions – Performance

ORIGINAL 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 the Size Effect category). 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 the Value Premium category). 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 risk premium, with the volatility priced into options higher than actual volatility (see the Equity Options category). 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 the Calendar Effects category for various investigations of this anomaly). 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 a few days 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 the Big Ideas and Fed Model categories). 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.

REVISED TEST STRATEGY

As of April 2009, we revised the above strategy as follows:

We simplified the strategy by focusing on short puts only, rather than short puts and covered calls. We still avoid leverage, such that the short puts are approximately 100% covered by cash. This change derives from accumulating research (see the Equity Options category) suggesting that puts tend to carry a higher volatility risk premium than calls.

We switched from IWN ETF options to the Russell 2000 Index options as a trading vehicle for the following reasons:

• The large bid-ask spreads on IWN inhibited changing positions prior to option expiration. In contrast, Russell 2000 Index options carry relatively small bid-ask spreads. The iShares Russell 2000 Index (IWM) ETF would also serve as a replacement for IWN on this basis alone.
• Russell 2000 Index options are cash settled, unlike IWM, such that holding to expiration leaves the trading account ready to sell puts again. In other words, the revised strategy automatically regularizes exposure to the market compared to the original strategy. The revised strategy is always idle from each monthly option expiration date to the beginning of the following turn-of-the-month interval.
• Russell 2000 Index options reduce trading costs compared to IWM because of the large size of the contracts (fewer contracts traded).
• Russell 2000 Index options trading gains/losses qualify, regardless of duration, as 60% long-term and 40% short-term per U.S. Code Section 1256.

The value premium is no longer a consideration in this revised strategy.

We will maintain a continuous record of trades for the original and revised test strategies for a while for ease of comparison.

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 calls 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. [Expired out of the money.]

10/3/08: Sell to open IWNVI puts expiring October 17, 2008 at strike price 61 (1.6% out of the money) against the account cash balance. (Delayed from 9/23/08 to observe SEC and Congressional interventions.) [Expired in the money. Fund shares delivered with strike price minus put premium much greater than closing price.]

11/7/08: Sell to open ITVKY calls expiring November 21, 2008 at strike price 51 (4.5% out of the money) against the account IWN holdings. [Expired out of the money.]

12/5/08: Sell to open ITVLV calls expiring December 19, 2008 at strike price 48 (5.4% out of the money) against the account IWN holdings. [Expired in the money. Fund shares called away with strike price plus call premium above closing price.]

12/23/08: Sell to open ITVMT puts expiring January 16, 2009 at strike price 46 (0.4% out of the money) against the account cash balance. [Expired in the money. Fund shares delivered with strike price minus put premium well below closing price.]

2/6/09: Sell to open ITVBT calls expiring February 20, 2009 at strike price 46 (3.1% out of the money) against the account IWN holdings.

2/17/09: Buy to close ITVBT calls expiring February 20, 2009. [Market fell so hard, bought back at $0.05.]

3/6/09: Sell to open ITVCH calls expiring March 20, 2009 at strike price 34 (5.8% out of the money) against the account IWN holdings. [Expired in the money. Fund shares called away with strike price plus call premium much less than closing price.]

3/25/09: Sell to open ITVPL puts expiring April 17, 2009 at strike price 38 (3.1% out of the money) against the account cash balance. [Expired out of the money.]

4/24/09: Sell to open RUWQK puts expiring May 15, 2009 at strike price 460 (4.0% out of the money) against the account cash balance (rounded to the nearest number of contracts). [Note that the revised test strategy starts with this transaction.] [With the sharp rise in the market, bought to cover this position on 5/4/09.]

5/22/09: Sell to open RUWRK Russell 2000 Index puts expiring June 19, 2009 at strike price 460 (3.8% out of the money) against the account cash balance (rounded to the nearest number of contracts). [With the sharp rise in the market, bought to cover this position on 6/1/09.]

6/24/09: Sell to open RUWSA Russell 2000 Index puts expiring July 17, 2009 at strike price 490 (1.0% out of the money) against the account cash balance (rounded to the nearest number of contracts). [Expired out of the money.]

7/27/09: Sell to open RUWTH Russell 2000 Index puts expiring August 21, 2009 at strike price 540 (1.5% out of the money) against the account cash balance (rounded to the nearest number of contracts). [Expired out of the money.]

8/25/09: Sell to open RUWUN Russell 2000 Index puts expiring September 18, 2009 at strike price 570 (2.3% out of the money) against the account cash balance (rounded to the nearest number of contracts). [Expired out of the money.]

9/25/09: Sell to open RUWVR Russell 2000 Index puts expiring October 16, 2009 at strike price 590 (1.4% out of the money) against the account cash balance (rounded to the nearest number of contracts). [Expired out of the money.]

10/27/09: Sell to open RUWWP Russell 2000 Index puts expiring November 20, 2009 at strike price 580 (1.2% out of the money) against the account cash balance (rounded to the nearest number of contracts). [Expired out of the money.]

11/25/09: Sell to open RUWXR Russell 2000 Index puts expiring December 18, 2009 at strike price 590 (0.4% out of the money) against the account cash balance (rounded to the nearest number of contracts). [Order on 11/24 target date not filled. Expired out of the money.]

12/22/09: Sell to open RUYMD Russell 2000 Index puts expiring January 15, 2010 at strike price 620 (0.6% out of the money) against the account cash balance (rounded to the nearest number of contracts). [Early entry takes into account unusually bullish market behavior around Chistmas. Expired out of the money.]

1/26/10: Sell to open RUY Russell 2000 Index puts expiring February 19, 2010 at strike price 610 (0.8% out of the money) against the account cash balance (rounded to the nearest number of contracts). [Order on 1/25 target date not placed due to software glitch. Expired out of the money.]

2/22/10: Sell to open RUY Russell 2000 Index puts expiring March 19, 2010 at strike price 630 (0.2% out of the money) against the account cash balance (rounded to the nearest number of contracts). [Expired out of the money.]

3/24/10: Sell to open RUY Russell 2000 Index puts expiring April 16, 2010 at strike price 680 (0.6% out of the money) against the account cash balance (rounded to the nearest number of contracts). [Expired out of the money.]

4/26/10: Sell to open RUY Russell 2000 Index puts expiring May 21, 2010 at strike price 730 (1.2% out of the money) against the account cash balance (rounded to the nearest number of contracts). [Expired well in the money and cash settled.]

May 2010: The test is on pause pending consideration of other tests.

PERFORMANCE

The following chart compares the performance of the test strategy to date with that of IWN prior to April 2009 and IWM as an investable proxy for the Russell 2000 Index since April 2009. After 38 months of testing, the average (arithmetic mean) monthly return for the test strategy is +0.11%, compared to -0.05% for buying and holding the ETFs. The test strategy has beaten buy-and-hold in 21 of 38 months. The standard deviation of monthly returns for the strategy is 7.2% for the strategy, compared to 9.8% for buying and holding the ETFs.

The test strategy returns include all trading frictions, as well as dividends and interest on cash balances.

The next chart compares the cumulative value of hypothetical $100,000 initial investments in the test strategy, buying and holding the IWN/IWN ETFs and buying and holding S&P Depository Receipts (SPY). It shows that the IWN/IWM ETFs have mostly lagged SPY. In other words, the combined size/value effect has been mostly negative over the test period. The compound (geometric mean) monthly growth rate for the test strategy is -0.15%, compared to -0.56% for buying and holding the IWN/IWM ETFs and -0.47% for SPY.