2011 – Wrapping Up The Year’s Trading

Ok. It’s January 3, 2012, the champagne’s has long since lost its fizz, my head has started to re-assume non-pumpkinlike dimensions, and its time to evaluate how we did last year.

I just read in today’s Wall Street Journal that the average hedge fund was down 3.7% for the year, according to data published by Hedge Fund Research. That about matches the NASDAQ, which ended the year down 1.8% but underperformed the DOW, which ended up 5.53%.

How did our performance match that? Well, we blew them out of the water. Our three stock sample portfolio grew from 100K to 148K in 9 months, about a 60% return. Our 6 stock portfolio, which ran for less time, started in June of 2011. Due largely to the extreme choppiness of that summer period – which wreaks havoc with most trading strategies, including ours – this portfolio showed a bit weaker results, but certainly nothing to complain about. Our 100K June portfolio has grown to 118K or 32% on an annualized basis. Not too shabby.

Lessons learned in this year’s trading? First and foremost, be patient!
When the summer whipsaws were punishing our trades, it was important to hold on for dear life. By doing so, we benefited handsomely when the market finally made up its mind.

The secrets of our strategy? Use a momentum indicator – we like the Commodity Channel Index, and stick to it fairly religiously. We may get a series of losses – 2 or 3 in a series are not unheard of – but then the subsequent gain usually more than makes up for that.

Lesson number 2? We also trade for customers holding monies in an IRA. As you may know, IRA’s are not permitted to short stocks. (In its infinite wisdom, the SEC judges shorting a stock to be much riskier than buying one – as in theory – a stock can rise to an infinite high so a short sale can produce infinite losses. )

So we use put options to attempt to gain value as the equities are falling. Well, our options portfolios performed poorly compared to long / short no option strategies. In analyzing our results, we ascribe this to 2 mistakes we made.

First, we traded options with expiry date only 1 month out. This time frame proved to be too short, and we got killed by time decay. Time erodes the value of all options (Theta), and the shorter the option the greater the decay. This will erode the value of your position, even when you are right in the direction of trading.

Second, in the stocks we chose to follow, the bid-ask spreads on my options were too large. If you are trading a stock and your momentum indicator signals you to reverse your trade – which will happen with frequency – you usually suffer little damage – perhaps a 30 to 200 basis point drop plus whatever friction results from transaction fees. On an option however, if you buy the put option then immediately sell it – with no movement of the underlying equity – you may see yourself sitting on a 10% loss due to the spread between bid and ask.

So what’s an IRA customer to do? There are 3 alternatives, and we will test them all:

  1. Only go long, use your signals to get out at the appropriate times.
  2. Use reverse ETF’S on sector ETF’s or broad market indices (e.g. QID) in lieu of the put on a given stock.
  3. Extend the expiry period of your put options – and only trade options that feature a spread of less than 2 percent. When option volatility is high, use straddles, strangles and calendar spreads to be a net seller and not a net buyer of the high priced options.

We believe the final choice will be the most successful, as our limited backtesting reveals, but the real proof of the putting will be in the eating.

 
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