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Author: JimZipCode Big funky green star, 20000 posts Feste Award Nominee! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 252728  
Subject: MI4: Options, Timing Date: 5/16/2006 5:23 AM
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May, 2006

What is MI? part 4 (of 6): Options, Timing

Contents
---- Options
Options?
Covered Calls?
---- Timing
What is the Arezi Ratio?
What is the Sjuggerud Model?
What forms of Technical Analysis and/or Market Timing have been used successfully with MI?



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Options
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Options?

Yeah.

This style of investing is likely to appeal to risk-junkies with a quantitative bent, and such a trader will inevitably start thinking about options at some point. Options conversations generate a fair amount of traffic here. MI generally discusses options in two ways:

• On the short side, as portfolio insurance, by buying puts: either on stocks that appear on short screens, or on indexes chosen with timing signals.
• On the long side, thru buying calls on stocks that appear on screens.

Occasionally there is also a little bit of Covered Call talk: but in general we do not use or endorse sell-to-open strategies.

So before going any further, we should point out that options are not for newbie investors, they carry substantial risks beyond those of regular stocks, and it is frighteningly easy to lose your shirt with options. And your pants. I find there is a lot to be learned from the options conversations here, especially some of the old ones: a great deal of insight about investing and trading and stock evaluation and how market makers operate etc etc etc. But reading about it and jumping into it are two entirely different things. If you've never traded options before, and you find these options conversations get you pumped up about it, then you absolutely need to do some due diligence. One place to start is the Chicago Board Options Exchange site: http://www.cboe.com/ . They have extensive tutorials (http://www.cboe.com/LearnCenter/Tutorials.aspx ). There's also a board at TMF devoted to options: Options - You Make the Call http://boards.fool.com/Messages.asp?bid=113013. I don't know if they have an FAQ or a good introductory discussion; but lurking there for a while might give you some insight. And it wouldn't hurt to get one of the books by MacMillan. (see the book recommendations section at the end of this FAQ)

So ok, the basic thinking is this. Suppose you have a way of “reliably” identifying a group of stocks that are likely to make a substantial price move in the next few months. You could buy the stocks. But you could buy options on those stocks, for a smaller money outlay, and garner huge returns due to the leverage inherent in options. The term or symbol you'll see a lot when we talk about options is 6/3. What this means is, buy options 6 months from expiration, and sell when they're 3 months from expiration. The notion of selling 3 months before expiration is based on the observation that the curve representing the time decay of an option price tends to get steeper in the final months leading to expiration: your options start losing value faster because the expiration date is getting closer. So the 6/3 theory is to allow a few months for the underlying to make a substantial move, then get out before the time decay starts to significantly erode your value. The options you buy with a 6/3 strategy are generally slightly out of the money; the holding period is intended to be long enough to give the underlying time to move enough that the options become in the money. For this to be workable, you'd need a stock screen with a good return for quarterly holds: that gives a reasonable percentage of stocks that move enough to change an OTM option to an ITM option. A fast market wouldn't hurt either. Lots of big money can be made in options in a great market: lots can be given away in a lousy or sideways market. The “sell 3 months out” side of the 6/3 definition is there for an important reason: but there's no reason the “buy” needs to be right at 6. Theoretically, 7/6 or 9/6 options ought to work well too. With LEAPS, you can buy 15/3 options: buy a LEAP call, hold that sucker for a year, sell 3 months before expiration.

This is not a strategy that produces consistent winners. As strategies go, it is not (to use a sports metaphor) a good singles hitter. It is a homerun strategy. You will make a large number of loud outs: then hit one huge homerun. The plan is that the few big winners pay for the (many) losers. It is speculative.

One of the interesting things about options is, you can have an underlying stock make a nice move, but still not make the gain you expect because of the implied volatility of the option. Many of our older screens that do well with quarterly holds, like the PEG variants or CAPRS or RS26 with HTD, have very high volatility: consequently the options are very expensive when you buy them, so you may not be making very much when you sell. That's a major problem, since this strategy is so reliant on homeruns: anything that reduces the magnitude of your big winners can make this strategy worthless. So one thing we have looked at with options is screening stocks for volatility. The XG family of screens, and RRS with volatility (sigma) adjustments, are attempts to identify “smoothly growing” stocks: theoretically they should not have forbiddingly high volatility, but should still have a good chance of moving enough to give you a good win with options.

It's important to emphasize that options are a wasting asset. At expiration, most options are worthless: if you hold all the way to the end, the option you spent some of your favorite dollars to buy can have a worth of exactly zero. The options strategies discussed here never hold til expiration: they are strictly trading strategies which sell long before expiration.

Another important point, related to the above, is that it's very easy to lose 100% of your investment with options. 100% = all of it. A funny thing about math is, you can have a long string of great returns, but if you multiply by just one zero (have a single minus 100% month), it's all gone. Never compound your options. Keep your options investment limited to a small portion of your portfolio, like under 10%. Rebalance strictly, so even after you have a homerun gain, when ou enter new positions your total options exposure is again under 10%.

There is a long history of fascinating options discussions here. These posts below are compendiums of links to earlier (like pre-2000) options conversations. These are a great place to start in looking to understand MI-style options, though there is probably some repetition among the
links. Especially check out the posts relating to Sparkfarkle's options demo, which are linked in at least one of the below posts.

BACKPOSTS - Options Update (Part 1), MI # 62554 3/16/2000
http://boards.fool.com/Message.asp?mid=12218719

BACKPOSTS - Options Update (Part 2), MI # 62555 3/16/2000
http://boards.fool.com/Message.asp?mid=12218721

Options Info & Resources, MI # 125932 5/27/2002
http://boards.fool.com/Message.asp?mid=17275874&sort=whole

Oh, also: Jamie has an options simulator at his backtest site. It is subject to some limitatations, eg assumptions about IV, but it's a great tool

http://www.backtest.org/OP

How to get hurt with options:

Options Enigma, MI # 89490 1/6/2001
http://boards.fool.com/Message.asp?mid=14044283&sort=whole

Very courageous post, that one. Great thread: here are a couple excerpts:

Options Enigma, MI # 89509 1/6/2001
http://boards.fool.com/Message.asp?mid=14045923
I've hesitated to say much. It's not that I don't have experience with them, having floor traded them in Chicago and having supervised and financed others who traded them. Rather my reluctance was due to discomfort with the idea that they were right for most MI investors. …value does matter in buying stocks. If it does in stocks, then it REALLY does in options. Buying calls continually and indiscriminately is a great way to lose lots of money. I know, 6/3 calls aren't indiscriminate, they are calls on high RS stocks. But part of the lack of discrimination is paying no attention to the implied volatility paid. Any professional will tell you that doing that on a regular basis is suicide. Personally, I don't see options as investments. They are speculations, leveraged ones at that. Anytime you speculate with a leveraged instrument, the odds are against you. So you've got to have a really strong reason for believing that this time the odds are tilted your way. RS alone isn't enough.

Options Enigma, MI # 89528 1/6/2001
http://boards.fool.com/Message.asp?number=89528&bid=100093
Options are the buzz saw of your investment portfolio, and defensive money management is the safety guard. Remove the safety guard and you will lose at least a finger, perhaps a whole hand.



Covered Calls?

Oh geez. Please read this huge thread; and then never ask about it again.

No Risk! Minus 3 Sigma>0. Possible? MI # 91390 1/27/2001
http://boards.fool.com/Message.asp?mid=14209667&sort=whole

Ok, there are a couple other things worth looking at:

Options “Model” and Index CC's, MI # 73436 2/1/2001
http://boards.fool.com/Message.asp?mid=14251662&sort=whole

30 months of covered calls, MI # 184089 2/19/2006
http://boards.fool.com/Message.asp?mid=23727309&sort=whole



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Timing
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What is the Arezi Ratio?

Back when Ben Graham was writing The Intelligent Investor, he had a simple metric for looking at whether stocks were “cheap”: he looked at his cost of capital by comparing stocks to the other main financial instrument, bonds. He used a version of what nowadays we would call the Fed Ratio: compare the earnings yield of stocks to the yield of bonds. If bond yields are higher, then stocks are overpriced and bonds are a better bet; if the earnings yields of stocks are higher, then stocks are fairly priced or underpriced, and they are a better bet. The “earnings yield” of stocks is, however many dollars of earnings you get per dollar of stock you buy; it's the inverse of the PE ratio. PE is price/earnings; the earnings yield is earnings/price or 1/PE. Graham talked about comparing stock earnings to the yields of high-grade bonds; that implies corporate bonds. The modern Fed Ratio looks at the yield on 10-yr Treasuries.

The Fed Ratio is calculated as:

(yield on 10-yr Treasury bonds) / (forward estimated operating earnings yield of the S&P 500)

which is equivalent to (bond yield) * (PE of the S&P 500), except remember to use the decimal expression of the bond yield. Last week the 10-yr Treasury bond yield was 4.6 percent: you'd need to write that as .046 when doing the multiplication, to get an answer in the right ballpark. If this ratio is below 1, then the earnings yield on stocks is greater than the bond yield, so stocks are considered attractive. If this ratio gets much above 1 – say 1.1, because it can make sense to pay a bit of a premium for stocks because of companies' ability to grow earnings – then the earnings yield on stocks is actually less than the bond yield, so stocks are considered overpriced compared to bonds. We often use a related measurement that we call the Arezi Ratio, named after a very knowledgeable investor on this board. The AR looks at shorter term Bonds: it's (90-day T-bill yield) / (trailing earnings yield of the S&P500), which again is equivalent to (90-day T-bill yield) * (S&P 500 PE) if you mind your decimals. Same basic relationship applies, although Arezi advocated looking at extremes: values under 0.75 indicate that stocks are attractively priced, over 1.25 indicate that stocks are overpriced. Arezi first dropped it on us here:

Lessons Learned, 4/1/2001
http://boards.fool.com/Message.asp?mid=14677883

No, I don't think he was playing an April Fool's Day joke.

These ratios tend not to be very useful as simple timing signals if you are going to trade. The market can under- or over-price stocks compared to some notional “fair” value for long periods of time before correcting. From 1997-2000 the Arezi Ratio rose from 1 to about 1.8: if you bailed in August of '97 because stocks were overpriced and were about to drop any minute, you missed out on the greatest bull market in history. Any trading strategy which includes selling should not rely solely on a simplistic measurement like this. The famous saying is “The market can stay irrationallonger than you can stay solvent.”

Other links on this:

http://boards.fool.com/Message.asp?mid=16416890&sort=whole
http://boards.fool.com/Message.asp?mid=23814390



What is the Sjuggerud Model?

A three-factor timing model. Introduced to us here:

So, It's This Simple! 9/13/2002
http://boards.fool.com/Message.asp?mid=17832585&sort=whole
First, is the market too expensive? (P/E ratio)
Second, are the Feds in the way? (Whether or not there's been a rate hike over the previous six months.)
Third, is the market acting badly? If the market is above its 45-week average, stock prices are strong. If the market is below its 45-week average, stock prices are weak.

Another link on this:

http://boards.fool.com/Message.asp?mid=23820560



What forms of Technical Analysis and/or Market Timing have been used successfully with MI?

We have not generally used any of the traditional TA indicators for entering & exiting positions. No head & shoulders tops, no double bottoms, etc. Most of the timing techniques we have looked at have been for asset allocation. When market conditions are risky, based on historical precedent, reduce your stock exposure: when it looks promising, based on historical precedent, increase your stock exposure. Two methods of doing this are the Arezi Ratio and the Sjuggerud Model.

Elan's Asset Allocation Method Backtested, 2/9/2005
http://boards.fool.com/Message.asp?mid=22039286&sort=whole

It turns out that simple regression analysis on the S&P500 or the Nasdaq can generate timing signals that give improved results over LTBH on the index. However, it's not clear those methods extend to trading our screens.

Regression Analysis Of The Market II, MI # 95445 3/4/2001
http://boards.fool.com/Message.asp?mid=14472058&sort=whole
(1) perform a moving regression on weekly SPX or NDX data, then (2) use the resultant tstat for the slope parameter estimate to decide whether to be invested or out of the market. The simple rule used was to BUY or be long when the tstat was above some positive value and to SELL or be out of the market when it was below the negative of that same value.

AA - Arezi Allocation: #1, MI # 98271 4/6/2001
http://boards.fool.com/Message.asp?mid=14717378&sort=whole
Both the approaches appear to help the S&P500 for the 31 year period, when considering the S&P500 including dividends and the benefit of interest income (using monthly CD rates). The benefit is seen in higher CAGR, lower GSD(M) and higher “monthly” Sharpe ratio.

Arezi Ratio Timing Approach, MI 130826 8/2/02</BR>
http://boards.fool.com/Message.asp?mid=17629747&sort=whole
couple the arezi ratio with a trend-following system…

Speaking of regressions, as discussed before RRS is a simple trend idea, very much a form of Technical Anlaysis, though it involves no chart interpretation.

Daily Data Analysis #4: Regress to Win, MI # 83661 10/21/2000
http://boards.fool.com/Message.asp?mid=13535576&sort=whole

In terms of real-life TA charting techniques, Nyua uses point & figure methods in her MI trading, has done for years, and has reported good results. Better than the base screens, if memory serves. I don't believe I've seen a comprehensive overview of the lifetime point-&-figure results vs straight trading on the underlying screens, and one is of course leery about drawing attention to something that lacks a backtests, but the results she posts about as she goes along have looked good. Here's a recent link:

MI RS26 wk HTD vs PnF versions 4/28, MI # 187665 4/30/2006
http://boards.fool.com/Message.asp?mid=24038515&sort=whole
I haven't seen anyone yet run a PnF version that did worse then the underlying screen. Does anyone have any experience doing so?
Moe


Some other timing stuff:

A request for Zeelotes, MI # 169522 2/12/2005
http://boards.fool.com/Message.asp?mid=22057330&sort=whole
He suggests being in (or using margin) only when the S&P is above its 12-month moving average and the yield on three-month commercial paper is below its 12-month moving average. No details other than that, but would it be possible to explore this approach?

Are We Fighting the Last Battle? MI # 170355 3/5/2005
http://boards.fool.com/Message.asp?mid=22160151&sort=whole
There has been much recent renewed focus on timing strategies, with a clear emphasis on risk aversion. TC, Arezi, MA, interest rates, the seasonal effect; combining all those into some comfortable asset allocation model that has more MIers “sleeping at night” mechanically. And this is a good thing, to be clear. However, comma: the next market cycle (the one we're in?) is not going to be the same as anything we've seen in the last ten years, or perhaps ever.

And I've mentioned The BMW Method before, which is pure chartist stuff but using a much longer time frame than usual. Interesting.

BMW FAQ
http://boards.fool.com/Message.asp?mid=23878864

There have also been some looks at using signals from timing services, like Timing Cube, Intelli-timer, EquiTrend etc. These looks have mostly involved futures trading, so I'm passing over them as out of the scope of this introduction.


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