Feb 2020 update

Now that much of my research work is done as part of my job, I don't have much time to devote to research on the sidelines. But here's a recap of what's still ongoing:

The yield curve play is still valid: https://www.fintrinity.com/marketview/trading-the-inverted-yield-curve-2/

Seasonality in indices can still be traded: https://www.fintrinity.com/blog/january-effect-idea-nov-2019/

Trading the outbreak is not the most convincing for me - I did it mainly to push myself to see what opportunities there are in situations like these, but still have not found anything with high conviction.

I've closed a good bit of my long TRY trades (using options to exit), as it keeps crawling lower (and the carry is diminishing) and so the risk reward is less than what it used to be.

As US markets are near ATH, I've taken the chance to add to long Puts and opportunistically selling Calls.

In FX markets, short term opportunities are still present in short USDCAD.

Commodity futures are still a go, riding on my past research, but not having the time to discover new things.

Opportunities in the Outbreak

While it's certainly no good thing that outbreaks occur time to time, the volatility that it induces in the markets produces opportunities that are quite rare (thankfully).

The first phase is an asymmetric play - to buy the medical / healthcare stocks. They may suffer a bit if the outbreak is less contagious than expected, but they may be lifted by the more general relief going back into the broader stock market.

The thing with exponential growth is that we hardly grasp / estimate it well - we are usually shocked by the numbers when it materializes. Hopefully (and it is my personal view that it won't) materialize as per the trend.

 
I do expect the trend to buck soon, and when it does, then phase 2 of the plan will be to exit phase 1 and get exposure in the beaten down stocks e.g. airlines, hospitality etc. probably by selling puts, trying to catch a falling knife with the hopes that the signal above is a strong enough and reliable one that we are about to turn the corner.

But above all I do hope for the safety and health of people. It's one of those things you don't mind losing money in a trade for.

Update on 19 Feb

The asymmetric trade in phase 1 did not play out - so that's a small loss, but I went in a bit early on phase 2 and managed to buy some things cheaper. Of note was some stocks which had very high implied vols, and I shorted some puts.

The January Effect – Idea for Nov 2019

Based off the posts from Part 1, the time has come to implement the bullish call for Nov and Dec.

TLDR: Buy 1-month 310 Calls  - you can't beat the index but you can get better Sharpe

One way to do this is to buy calls, especially since now VIX is quite low. The question is which strike to buy? Buying deeper ITM would cost us a lot, but knowing that Nov isn't a particularly high-skew month also means that many OTM calls would likely end up worthless.

Profiling the equity curve of a hypothetical backtest would help. Here the option prices for each strike is taken and simulated through all the years of % change to obtain the option portfolio equity curve. It takes into account the premium paid.

Naturally, the lower the strike, the more it resembles an outright investment in SPY. Further OTM calls have an equity curve that is highly dependent on very good years, but minorly decline in most years.

A very crude way to evaluate this balance of a smoother equity vs lower total profits is the good old Sharpe ratio. The current price of SPY is 306, and the optimal Sharpe is at 309, just at 1% above current price.

Of course, lots of historical assumptions are inbuilt, but at least it's an answer and a starting point.

Reconstructed equity curves for each strike vs SPY equity (in price points)

Brexit No Deal – Custom Payoff Strategy

Here we look at constructing a customized payoff for this event.

Betting site odds are 7/1 for No Deal: Bet $1000 on No Deal

Buy ATM GBPUSD Call for $2000 at strike 1.2650 (spot is at 1.2640) - breakeven is at 1.2850 which is 1.7% up (if including loss from bet, 1.2950, which is 2.5% up)

Deal No Deal
GBP up -1000 from Bet

+ ??? from Call

Net > -1000

+7000 from Bet

+ ??? from Call

Net > +7000

GBP down -1000 from Bet

-2000 from Call

Net -3000

+7000 from Bet

-2000 from Call

Net +5000

Limited risk payoff with maximum downside of -$3000

Assign probabilities into the 4 scenarios to get expected value, example:

Deal No Deal
GBP up 70% 5%
GBP down 5% 20%

Unfortunately, I think that when the Deal scenario plays out, the GBP will not rise enough to cover the cost of the bet and the premium paid.

Also, I don't have access to online betting sites, so this will only remain a theoretical trade.

The January Effect – Part 2

Continuing from Part 1

Comparing between strategies

S2 strategy invests in months {1,3,4,7,10,11,12} and yields better Sharpe and higher total return than the benchmark. It also has less negative skew.

S1 invests in only 4 months of the year {3,4,11,12} and so the total profit is much lower. The Sharpe does not improve, but the skew is significantly improved – it is now positive.

S1b squeezes out a little more total return by shorting month 9, giving us less of a max DD, but does not improve on the Sharpe nor the skew, so it might not be worth the effort.

Because this is an active method, the number of trades needed is proportional to the number of months. S2: 7, S1: 4, and S1b: 5.

Active method equity curves

Using the active method, we can see that the curve is significantly smoother than the benchmark, especially for S1 strategies.

Passive method

The passive method is what we normally do in real life – a hypothetical growth of $1. We do not rebalance the amount, but simply let it grow. The percentage returns are compounded, not simply added as per previous method.

Conservative strategies (like S1) are penalized because they tend to miss out on some of the compounding gains accrued in bull runs. This makes a sizeable difference in the long run.

The passive strategy comparisons show that S2 allows us to beat the benchmark, with slightly lower SD and drawdown measures.

S1 strategies are far superior in terms of Sharpe, but don’t eke out as much of a profit. To solve that, use leverage.

Using leverage of 1.5x, we can get the S1 strategies to beat the the total return of S2 and the benchmark, with somewhat similar SD and drawdown.

 

However, implementation is not so simple – we will need to find a way to get the 1.5x monthly return of the index, and keep compounding it. It’s not as easy to implement as S2.

 

Conclusion

Following a simple strategy like S2 can give us better total and risk-adjusted returns than the benchmark.

Continue reading "The January Effect – Part 2"