Using Options on 2018’s Likeliest Winners in Global Stock Markets
Options are a versatile tool for investors. They are often associated with short term trading and can provide leveraged exposure to a selected market for as little as a few minutes. This can be a valuable tool for traders looking to benefit from a short term news event.
While short term trading is commonly associated with options, this investment vehicle can also be used with long term investment strategies. To illustrate how options can be useful for longer term investors, we will flip another investment belief on its head.
Value Is a Time Tested Strategy
Long term investing is often associated with value investing strategies. Value investors seek out stocks that are trading below what investors believe is the company’s fair value. These stocks are often found with popular indicators like the price to earnings (P/E) or price to book (P/B) ratios.
The P/E ratio might be the more popular tool among individual investors, but the P/B ratio has been extensively studied by the academic community. Studies which compare different fundamental indicators generally show that any indicator can be applied successfully.
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One of the first major studies was published in 1985. In this study, future Nobel Prize winning economist Richard Thaler worked with Werner De Bondt to publish a paper called “Does the Market Overreact?” in the Journal of Finance.
In this study, they reviewed the returns of stocks over three year periods. Each stock was placed into a group based on its performance. The stocks with the largest gains were placed a “winners portfolio” and the worst performing stocks were then placed in a “losers portfolio”.
The two economists then tracked each portfolio’s performance against the broad stock market index for the next three years. They found that the losers portfolio consistently beat the market index and the winners portfolio consistently under performed the market index.
Source: Does the Market Overreact?
They theorized that investors overreacted and created overvalued and undervalued stocks.
For the loser stocks, investors overreacted to bad news, driving prices down too far. As other investors saw value in the beaten down stocks, they began buying and pushed the prices back up. In the case of the winners portfolio, the overreaction was to the up side and after pushing prices up too much, a decline occurred.
In other words, this study demonstrated that value investing worked because the stocks in the losers portfolio had a lower P/B ratio, on average, than the stocks in the winners portfolio.
But, Value May Not Be the Best Strategy for the Long Term
Subsequent studies found other ways to beat the stock market in the long run. One example is another Journal of Finance article. A paper by Narashimhan Jegadeesh and Sheridan Titman called “Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency” was published in 1993.
This paper began by sorting stocks by their returns and forming portfolios from the best and worst performers. The authors tested what happened if investors had bought stocks that had been the top performers and sold short the stocks that were the worst performers in the past.
They looked at performance periods ranging from three months to twelve months. Their results were consistent. The winners of the past continued to deliver market beating results in the future. These portfolios were rebalanced frequently.
As an example of rebalancing, consider a portfolio with a twelve month holding period. This portfolio would be formed based on the results of the previous twelve months. A three month holding period would be used for portfolios based on performance over the past three months.
This result became known as momentum. It is now widely accepted that momentum portfolios can consistently beat the market averages.
A 2013 Journal of Finance article tested the idea of momentum in markets around the world. “Value and Momentum Everywhere” was written by Clifford S. Asness, Tobias J. Moskowitz, and Lasse Heje Pedersen.
This study looked at stocks in the US, the United Kingdom, Europe, Japan and other markets. Some of the results are summarized in the charts below. In all cases, except Japan, momentum portfolios outperformed value portfolios. A combination of the two did the best.
Source: Value and Momentum Everywhere
Other research has found momentum strategies deliver market beating results in other markets around the world. Papers have been published showing momentum exists in both developed ones like the markets Asness et al studied and emerging markets.
Applying This Research With Options
There are a number of ways that this research could be applied. One of the simpler methods to apply this research is to focus on momentum. We know from the research that momentum exists in markets around the world.
There are exchange traded funds, or ETFs, that are available to trade just like stocks. However, the ETF is a pooled collection of assets that is generally managed to track an index. For example, an ETF tracking the S&P 500 index allows an investor to track the gains or losses of the index without needing to own 500 stocks.
ETFs are similar to mutual funds but ETFs are priced continuously through the trading day while mutual funds are priced just once a day, after the close. This means investors can buy or sell ETFs at any time in the day rather waiting until the end of day as they must do with mutual funds.
There are ETFs available to track major market indexes, sector indexes and indexes of stock markets in other countries. These international ETFs could be used to implement a trading strategy.
There are a number of web sites that allow traders to sort ETFs based on performance. One of these sites is with the free stock screening tool available at FinViz.com. At this site, you could screen for a variety of fundamental factors or performance.
The figure below shows the results of a sort based on performance over the past year. This screen was limited to ETFs and can be used to find the ETFs tracking international stock markets with the largest gains over the past year.
To benefit from their expected outperformance in the next year, call options can be used. A call gives the buyer the right, but not the obligation to buy 100 shares of a stock or ETF at a predetermined price for a predetermined period of time.
A Specific International Momentum Strategy
From FinViz.com, we know that one of the best performing international ETFs over the past twelve months has been iShares MSCI China ETF (NYSE: MCHI). There are long term options expiring in May 2018 available for MCHI.
A trader could buy a May 2018 $65 call in MCHI for about $3. MCHI gained about 40% in the past year with about half of that gain coming in the past six months. If the stock were to make a similar move in the next six months, this option would be worth at least $13, a potential gain of more than 330%.
At expiration, a January 2019 call in MCHI could be bought. The maximum risk when buying calls is the amount paid to purchase the call.
To diversify, calls in other top performers should also be bought. iShares MSCI South Korea Capped ETF (NYSE: EWY) January 2019 $75 calls could be bought for about $6.50. WisdomTree India Earnings ETF (NYSE: EPI) January 2019 $27 calls could be added for about $$2.50.
This portfolio of three call options could be the starting point of a long term strategy which could be rebalanced every six months or every year to always maintain exposure to the best performers.
Buying long term calls is an example of how options are a versatile tool and could meet many of your trading objectives. In this trade, options provide the opportunity for large gains and defined risk that should be lower than owning the stock.
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