How to trade options based on history
Seasonal anomalies are an interesting field of study in the stock market. This has actually been an interest pursued by the most recent winner of the Nobel Prize in Economics, Dr. Richard Thaler.
“Economics is distinguished from other social sciences by the belief that most (all?) behavior can be explained by assuming that agents have stable, well-defined preferences and make rational choices consistent with those preferences in markets that (eventually) clear.
An empirical result is anomalous if it is difficult to “rationalize,” or if implausible assumptions are necessary to explain it within the paradigm.”
Among the anomalous results found in the stock market is the January Effect which is the fact that stock prices tend to rise in January, particularly the prices of small firms and firms whose stock price has declined substantially over the past few years.
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Researchers also found that risky stocks earn most of their risk premiums in January. This will be an important insight to keep in mind as we head into the end of the year. We will share several trading strategies based on this anomaly.
Thaler also studied what he called the weekend effect, the holiday effect and the behavior of prices at the turn of each month and within the day. It is the turn of month effect we want to dig into in this article.
A Predictable Pattern Within the Month
Traders have long known that some days of the month seem to deliver consistently strong returns. The period around the turn of the month is consistently the most profitable. Some studies identify the ideal period as the last two trading days and first five trading days of each month.
A test of this idea is shown in the chart below. The profit factor for each trading day of the month is shown in the chart. The profit factor is the ratio of the sum of winning trades to the ratio of the sum of losing trades. It is a metric used to assess the profitability of a trading strategy.
A profit factor of 1.0 shows that a strategy is profitable. The holding period consisting of those seven trading days includes the best day of the month and several other days that show consistent profits.
One reason for this effect was offered in a 1990 Journal of Finance article by Dr. Joseph Ogden. He found that a significant amount was paid to investors around the turn of the month.
Specifically, Ogden found that 45% of all common stock dividends, 65% of all preferred stock dividends, 70% of interest and principal payments on corporate bonds, and 90% of the interest and payments on municipal bonds are made on either the first or last business day of each month.
Ogden also noted that there are a large number of deposits made to retirement accounts at this time of the month. He believed what he called the “regularity of payments” explained this anomaly.
This effect was quantified in a textbook titled Fundamentals of Investments which was written by Bradford D. Jordan and Thomas W. Miller.
They studied market returns from 1962 through 2004 and found that the turn of the month period delivered average gains that were about 7 times more than the rest of the month. In other words, just one third of the days delivered significant outperformance.
Because the holding period of this strategy is just one third as long as a buy and a hold strategy, the turn of the month strategy has less risk than a buy and hold strategy.
Trading the Strategy
This idea can obviously be implemented in a number of ways. The first step involves simply looking at a calendar.
This calendar shows that the last two trading days of October are October 30 and 31. The first step in the strategy would be enter the trade at the open on October 30.
The second step in implementation is to find the exit date. The fifth trading day of November will be November 7 this year. The trader will need to enter an order to exit the position at the close on November 7.
To trade the strategy, a trader could use stocks, ETFs or options. ETFs or options would provide the most direct exposure to an index. For example, SPDR S&P 500 ETF (NYSE: SPY) could be used. This ETF could be bought and sold on the required dates to implement the turn of the month strategy.
There are two potential problems with this approach.
First, the cost of owning SPY can be relatively high. This ETF is priced near $250 per share. If the stock market delivers a gain of 1% over the holding period, a typical return for the week or so the trade is opened, the gains will be small in dollar terms.
This is especially true for investors with smaller accounts. Assuming a $5,000 investment in SPY delivers a 1% gain, that would generate $50 in gains. Over the course of the year, this would add up to just over $600 if the gains were steady and compounded.
While this would be a significant return on investment in percentage, the relatively small amount of dollars gained makes this a slow but steady approach to increasing wealth.
There is also a risk of significant loss when buying a stock or an ETF. To avoid that risk, traders can buy options. This options trading strategies has limited risk.
A Call Option on SPY
To potentially benefit from Thaler’s turn of the month anomaly, a trader can buy a call option. A call provides a way to profit from the expected up move in SPY without the risk and up-front capital outlay of outright stock ownership.
An option costs significantly less than the ETF and the smaller initial outlay also gives the buyer a chance to achieve significantly larger percentage gains.
The maximum loss is limited and occurs in this case if you still hold the call at expiration and SPY is below the strike price. The option would expire worthless, and the loss would be the price paid for the call option.
The potential risks and rewards of the trade are shown in the diagram below.
Source: The Options Industry Council
This strategy calls for selling the position on November 7. That means options expiring on November 8 are an excellent fit for the strategy. The November 8 $255 call could be bought for about $2.25.
Since each contract covers 100 shares, this trade should cost about $255 to open. The downside risk is limited to the amount paid to open the trade.
If SPY rises by 1% in the time this trade is open, the call could be worth $3 or more, delivering a gain of about 33% in less than two weeks.
This strategy could be applied every month, buying a call that is near the money or creating a spread with a near the money call, to benefit from Thaler’s anomaly research. It’s a simple way for traders to share in the upside of Nobel Prize winning research.
Traders could also use other ETFs or other strategies to benefit this strategy. More aggressive traders could consider PowerShares QQQ ETF (Nasdaq: QQQ) while more conservative traders may be more comfortable with SPDR Dow Jones Industrial Average ETF (NYSE: DIA).