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Using Options for Long Term Trading Strategies

Using Options for Long Term Trading Strategies

Many investors prefer to use a strategy with predefined buy and sell rules. This allows them to benefit from long term trends in the stock market without being subject to emotional responses. Investors who don’t use trading strategies may think they are too complex to follow with limited time or a small account.

Trading strategies, or systems, can indeed be complex. It’s possible to trade using intraday data and to generate dozens of signals a day. These systems could be fully automated but even if automation frees you from watching a computer all day, these systems still may not be right for small investors.

options trading strategies that trade frequently will generally be pursuing very small profits on any given trade. To benefit from a small average gain per trade, it is best to have a large account size or to use leverage. Many individuals will not be able to use strategies with smaller accounts.

While strategies can be complex and active, they can also be simple and require trading just a few times a year.

A Simple Strategy for Long Term Investors

One of the simplest strategies is one described in a paper called A Quantitative Approach to Tactical Asset Allocation. The name may sound complex but the idea in the paper will take just a few minutes a month to follow and the results could well be worth the small amount of effort required.

The strategy rules are to buy when the price of an ETF is above its 10 month moving average (MA). The strategy sells and moves to cash when the price closes below the 10 month MA. That is the complete set of rules. There is no short selling and the required data can be found at free web sites like StockCharts.com or TradingView.com.

If monthly charts are not available, you could use a 200-day moving average since there are about 20 trading days in a month. A 40-week moving average could also be used. Either way, the data only needs to be checked once a month. This paper tested the strategy based on the close of the last day of the month.

The paper included detailed test results. Below are the long term results for using this strategy with the S&P 500. The SPDR S&P 500 ETF (NYSE: SPY) could be used for trading. The column labeled timing shows the strategy returns compared to buy and hold which is shown in the S&P 500 column.

While this strategy is a winner in the long term, it is important to understand that “The timing system achieves these superior results while underperforming the index in roughly half of all years since 1901.” The outperformance comes from avoiding bear markets.

The next chart shows the performance since 1990. The red line shows the strategy’s performance. Periods of time when the line is horizontal show times the strategy is out of the market and in cash. Notice the strategy underperformed in the bull market in the 1990s.

This strategy delivered a gain of 1.33% in 2008 and its worst year was 1973 when the strategy lost 15.36%. The S&P 500 lost 36.77% in 2008 and just 14.69% in 1973.

Going Global for Diversification

The paper also reviews the results of a more diversified strategy. This strategy uses five asset classes:

  • US Large Cap stocks with the S&P 500
  • Foreign Developed stocks with the MSCI EAFE
  • US 10-Year Government Bonds
  • Commodities with the Goldman Sachs Commodity Index
  • Real Estate Investment Trusts through the NAREIT Index

Each of these assets can be traded with an ETF, although the ETFs will not exactly match the index results:

  • SPDR S&P 500 ETF (NYSE: SPY)
  • iShares 7-10 Year Treasury Bond ETF (NYSE: IEF)
  • PowerShares DB Commodity Tracking ETF (NYSE: DBC)
  • Vanguard REIT ETF (NYSE: VNQ)

The paper recommends allocating 20% of the portfolio to each asset classes. The same rules apply for all assets. The asset is a buy when the close is above the 10 month MA and cash is held when the asset is below the 10 month MA. The results for the five asset classes is market beating in a test from 1973 through 2012.

The strategy beat the market and the largest decline (the MaxDD or maximum drawdown) was less than 10%. That indicates the strategy greatly reduces volatility.

A Diversified Portfolio on a Budget

Reducing volatility in a long term investment strategy is important because an investor may need immediate access to their money. The MaxDD of 46% for the buy and hold (B&H) strategy could be life changing.

Consider an investor who planned to retire in early 2009. The buy and hold investors would have lost nearly half of their account at that time. This could cause them to delay retirement, a severe and life changing consequence caused by a bear market. An investor losing just 9.5% could retire on time.

This strategy could be useful for investors but small investors may worry their account is not large enough to split among five assets. Or aggressive investors might want to take advantage of the steady growth to potentially boost their returns with leverage.

There are options available on each of the ETFs listed above. That means an investor could simply buy a call option when the strategy is on a buy signal and move to cash when the system is on a sell signal. Very aggressive investors could consider buying a put option instead of holding cash.

Putting It All Together

To implement this strategy, very little work is required. Prices would need to be reviewed once a month. At the end of each month, the price of each ETF would be compared to its 10 month MA. If the price is above the MA, the investor would want to own a call on that ETF.

Call options are available with various exercise prices and several different expiration dates.

When using options instead of stocks, it will usually be best to use an “at the money” option. This is an option with an exercise price close to the current price of the stock or ETF. For example, if the ETF is priced at $63, a $65 call could be bought.

The alternatives could be a $60 call or a $70 call. The $60 call, which would be considered “in the money” would be more expensive. The $70 call, which would be considered “out of the money” would require a large move in price before it would be profitable.

The next question to address would be which expiration date to buy. There will generally be options expiring within the next month and as far as six months or more into the future. The best one to use depends on the individual trader.

At the money call options expiring sooner will cost less. This could make them preferable for smaller investors. But, they will require more frequent trading. A new option will need to be bought if the strategy is still on a buy signal when the option expires.

Options expiring further in the future will cost more but will require less trading. If trading costs are a factor, these will be preferable to short term options.

In general, options expiring in two to four months may be the best choice for investors using a strategy like a strategy described in the paper. This will balance the trading costs with the holding period. This is a long term strategy and could benefit from long term options.

Options could provide a way to benefit from short term or long term strategies. This can help small investors grow their account, benefiting from diversification and time tested rules without the need for significant capital.