Using Options to Increase Your Investment Horizons
Hedge funds take different approaches to investing. Some pick stocks with value methodology while others use activism to try to change a company and improve their investment performance. Others use a variety of technical strategies and some simply invest in ideas based on the news.
There really is no typical hedge fund. The same can be said for mutual funds, registered investment advisors and pension funds. There are a variety of investment styles and there are managers who use almost every approach in their bid to generate better than average returns.
Few large investors place all their assets into a single style. Many large pension funds, for example, assign parts of their portfolio to a number of different managers. This allows them to benefit from different strategies and not have to select a single strategy that they believe will work all the time.
Some funds even combine strategies to create a single system. Renaissance Technologies’ Medallion Fund, for example, uses dozens of “strategies” that run together as one system. This fund has been called “the pinnacle of quant investing. No one else is even close.”
Medallion demonstrates the power of using different strategies. The fund is notoriously secretive but Bloomberg reported returns nearly a year ago that showed how successful the firm was. From 1988 to 2016, a $1,000 investment would have grown to more than $13 million in the fund, an average annual return of more than 40% a year over more than two decades.
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For small investors, the appeal of this approach is obvious. But, the problem with this approach is the fact that they have limited trading capital. This can prevent small investors from benefiting with strategies they cannot find in mutual funds or ETFs which require small initial investments.
Calendar Based Investing Can Be Useful
Among the strategies individual investors may find difficult to access are seasonal strategies. There are a number of reasons seasonal patterns appear in the stock market, many related to money flows. There are simply certain times of the year when investors add more to their accounts.
For example, stocks have a tendency to perform better than average in early April. This is likely due to the deposits investors are making into retirement accounts as the tax deadline nears. There is also a tendency for stocks to underperform near the end of April, as investors are raising cash for tax bills.
While it may not be comfortable to use the calendar to trade, Medallion uses a number of strategies that may not be comfortable for individuals to follow. They look for strategies that make money and are not widely traded.
The firm’s cofounder once said, “The point is that, if there were signals that made a lot of sense that were very strong, they would have long ago been traded out.”
These strategies include seasonal trades, or trades based on the calendar rather than price or value can be employed by hedge funds but are not generally available to individual investors. That can be unfortunate since certain times of the year seem to provide ideal trading opportunities.
Some seasonal trades are intended to last for just a few days. Others may last a week or even a few months. One of the longer lasting strategies is based on the way that stocks perform in the fourth quarter of the year.
Stock returns can be calculated over a time frame. When looking at quarterly results, according to the Stock Trader’s Almanac, it becomes apparent that the fourth quarter, the period of time including October, November and December, is the best performing quarter of the year.
Since 1949, the Dow Jones Industrial Average has gained an average of 3.9% in those three months. This is better than the average gain of any other quarter. The average gain in the first quarter of the year has been 2.2%. The second quarter’s average gain is 1.5% and the third quarter average is 0.5%.
The same pattern is seen in the S&P 500 where the average fourth quarter gain is 4.2% and in the Nasdaq Composite average where the average gain is 4.5%. For the Nasdaq Composite, data only goes back to 1971 when the index was established.
Independent research found the fourth quarter gains are statistically independent of the market’s performance in the previous quarter. The results are also independent of the index’s year to date performance.
This indicates that even though the stock market has delivered strong gains since the beginning of the year, the fourth quarter of 2017 is still likely to deliver better than average gains to investors.
These results are also independent of the presidential cycle. Stocks show a distinct pattern that follows a four cycle associated with the presidential election. In general, stocks are weakest in an election year and in the year after the election and stronger in the other two years.
Some analysts believe this is due to politics. New presidents tend to take actions they know could slow economic growth, like raising taxes, immediately after the election since they will not face voters again for some time. The runup to the next election results in policies that boost investor’s spirits and the stock market.
Using Options to Trade Seasonal Patterns
Trading on a bullish fourth quarter is a relatively straightforward trade. You could simply buy shares of an ETF that tracks one of the major stock market indexes. SPDR Dow Jones Industrial Average ETF Trust (NYSE: DIA) or SPDR S&P 500 ETF (NYSE: SPY) could be used.
There is no ETF tracking the Nasdaq Composite Index. However, there is an ETF that tracks the Nasdaq 100 index which has a high correlation to the Composite Index. PowerShares QQQ Trust, Series 1 (Nasdaq: QQQ) tracks the Nasdaq 100.
One problem smaller investors face is the high cost of the ETFs. All three of these ETFs trade for more than $100 a share and that high price limits the amount a small investor can buy, even if the investor is using margin to potentially double or quadruple their buying power.
Fortunately, the expectation of a price increase can be implemented with a number of different options strategies. Of course, the simplest strategy would be to simply buy a call. That is also, potentially, the best strategy to use in this trade.
Buying a call is a strategy that offers limited risk and, in theory, unlimited potential upside. The upside is limited by how high prices can rise before the option expires.
Because the underlying ETFs trade for high prices, the options will be somewhat expensive. For example, the lowest priced ETF is QQQ which still trades for $144.32 per share. Buying 100 shares of this option would cost nearly $15,000.
A call option expiring on December 29 is available at a much lower cost. A QQQ December 29 $150 call could be purchased for about $2.50. Each contract covers 100 shares so the cost of this call would be about $250.
This is just 1.7% of the cost of 100 shares but may still seem expensive. Traders could create spreads to lower the cost but a spread will cap the upside potential of the trade. Limited upside is the tradeoff for lowering the cost of the trade. It seems best to avoid a spread with this strategy.
To lower the cost, traders could consider increasing the exercise price of the option, using a call with an exercise price of $155 or $160, for example. These calls will have lower potential gains than the $150 but could be best for a trader looking to enter the trade with less than $100.