Hi, my name is Jay and I am a Seasonalaholic.  Now typically when someone confesses to being an “aholic” of some sort or another it because they recognize they have a problem and wish to correct it.  That’s not the case here.  In fact the “support” group that I belong to is not “Seasonalaholics Anonymous” but rather “Seasonalaholics Unanimous!” (OK, in the interest of full disclosure, so far I am the only member and yes, the monthly meetings aren’t terribly lively, but I digress).

Still I can’t help but think there are others out there who might join someday – especially after they consider things like the seasonal tendencies for retailing stocks.  To whit: what would have happened had an investor invested in Fidelity Select Sector Retailing fund (ticker FSRPX):

-During the months of February, March, October and November

-And then earned 1% of annualized interest while out of the market the other 8 months.

The answer is contained in Figure 1 which displays the growth of $1,000 invested as described above.

Figure 1 – Growth of $1,000 invested in FSRPX during February, March, October, November (blue line) versus buying and holding the S&P 500 red line) since January 1988.

Now it is pretty impossible to not notice the, ahem, “slight drawdown” experienced during the October, November 2008 period.  Still, despite the fact that I have tried very hard scrub that particular time period from my memory bank, I still have some vague recollection that virtually no sector of the stock market was left unscathed during that period.  And the rebound has been pretty nice.

So is this really a viable strategy?  Well, under the category of “Everything is Relative”, Figure 2 displays the year-by-year performance of this “system” versus buying and holding the S&P 500.

Figure 2 – “System” versus S&P 500 Buy and Hold

Summary

The difference in the average annual return is not large (+10.9% for the system versus +9.6% for the S&P 500).  But this difference adds up over time.  Since January 1988 the system has gained +1,115% versus + 648% for the S&P 500 (while only being in the market 33% of the time. The true “numbers geeks” will notice that the standard deviation of annual returns for the system is only 2/3rds as large as that for the S&P 500 – i.e., much less volatility).

So I ask again, is this really a viable strategy?  Perhaps.  But the truth is that it can get a whole lot better – as I will detail the next time I write.

Jay Kaeppel

There are a virtually unlimited number of ways to play the financial markets.  This is especially true in the area of options trading, where a bullish trader can pick from at least at a dozen different strategies (buy call, buy a bull call spread, sell a bull put spread, collar, out-of-the-money calendar spread, etc., etc.).

At some point it can all become a bit overwhelming to the quote, unquote, “average investor.”  So sometimes the place to start is, well, anywhere, so long as that anywhere has a beginning and an end and a logical progression to it.  What does that mean?  It means I am going to walk through “one way to play.”  I make no claim that it is the “best” way, or even a “great” way.  But that’s OK because the purpose here is not for you to rush out and start trading with it, but rather to stimulate your own thinking on the subject.  In other words, hopefully in reading this a “light” will go on for you in regards to your own trading.  So here goes.

Jay’s “Light” Option Trading Strategy

This strategy involves a set of steps designed to generate a bullish option trade based on a logical set of criteria.

For this strategy we will look for a couple of things:

1. A “catalyst” to tell us when to buy call options.

2. Stocks that enjoy good option trading volume and tight bid-ask spread.

3. Stocks that are performing well overall.

4. Stocks that have experienced a recent pullback and may now be due for a bounce.

#1. The “Catalyst”

We will look for ticker SPY to be above its 200-day moving and for the 3-day RSI to drop to 20 or below and then reverse to the upside.  Figure 1 displays a number of such signals.

 Figure 1 – “Catalyst” Buy Signals (Courtesy AIQ TradingExpert)

#2. Stocks with good option volume and tight bid/ask spreads.

In Figure 2 we see the “Stock List Filter” report from www.OptionsAnalysis.com.  This list contains 493 stocks that trade at least 1,000 options a day and those options have an average bid/ask spread of less than 2% (only the top part of the list is visible in Figure 2). Figure 2 – Stocks with good option volume and tight bid/ask spreads (Courtesy: www.OptionsAnalysis.com)

#3. Stocks that are performing well overall

Next we take the stocks shown in Figure 2 and run them through the “Channel Finder” routine in www.OptionsAnalysis.com.  We will look for the top 100 stocks based on the strength of their “Up Channel”.   We overwrite “My Stock List” with just those 100 stocks.  The output list appears in Figure 3. 

Figure 3 – Stocks with best UP Channel (Courtesy: www.OptionsAnalysis.com)

In Figure 4 we see ticker SFUN with a very strong recent Up Channel Figure 4 – Ticker SFUN with Up Channel (Courtesy: www.OptionsAnalysis.com)

#4. Stocks that have experienced a “pullback”

Lastly, we will look through the 100 stocks still on our list for those that have experienced a 3-day RSI of 35 or less within the past 5 trading days.  As you can see in Figure 5, only 19 stocks now remain for consideration.Figure 5 – Stocks that have had a 3-day RSI reading of 35 or less in past 5 days (Courtesy: www.OptionsAnalysis.com)

The Next Step: Finding a Trade

From here a trader can use whatever bullish option strategy they prefer to find a potentially profitable trade among these 19 stocks.  For illustrative purposes we will:

-Consider buying calls with 45 to 145 days left until expiration and Open Interest of at least 100 contracts.

-Initially sort the trades by a measure known as “Percent to Double”, as in “what type of percentage move does the underlying stock have to make in order for the option to double in price?”

-Once we get that list e will sort by “Highest Gamma” in an effort to get the most “bang for the buck.”

We see the output list in Figure 6. 

Figure 6 – Trades sorted by “Bullish % to Double, then by Highest Gamma” (Courtesy: www.OptionsAnalysis.com)

The top trade listed in to buy the MRVL Feb 2014 14 Call @ $0.73 (or $73 per option)

In Figure 7, we see that MRVL rallied nicely within a few weeks from 13.61 to 15.81.Figure 7 – MRVL rallies (Courtesy: www.OptionsAnalysis.com)

In Figure 8 we see that the Feb 14 call option gained 169.9%. Figure 8 – MRVL 14 call rallies sharply (Courtesy: www.OptionsAnalysis.com)

Of course there is also the whole topic of what to do with this trade: close it, sell some, adjust it, etc.  Sorry folks, that’s  beyond the scope of this article.

Summary

So does every trade work out this well?  That reminds me of a joke.  A salesman rings he doorbell of a home and a 12–year old boy answers the door.  The boy has a beautiful woman on each side, a drink in one hand and a big cigar in his mouth.  Momentarily stunned the salesman finally manages to ask hesitantly, “Um, is your mother home?”

The boy removes the cigar from his mouth, looks straight at the salesman and asks, “What do you think?”

Same answer here.

Still, a logical set of steps is a good place to start.

If you are interested in a Promo Code for www.OptionsAnalysis.com, please leave a comment to that effect on my blog

Jay Kaeppel

For the record, I am one of those guys who typically likes to develop his own trading methods.  Call it pride, stubbornness, or just plain paranoia, but I like to know that the any method I may use fits with my own personality.  Of course, it is still important to keep an open mind and to consider new ideas when they pop up in front of you.  One that I like a lot is a trading method developed by a former colleague of mine.  His name is John Broussard and he is the developer of www.OptionsAnalysis.com

John developed a system called “Darknet” for trading stocks and/or options based on his own proprietary trading logic.  John was kind enough to share the trading logic with me.  I am not at liberty to disclose it here (partly because I am still not entirely sure I understand what he was talking about.  Which come to think of  it, is probably why he was comfortable sharing the logic with me in the first place.  But I digress).

In any event, while a few of the calculations, ahem, “push my limits of understanding”, I understand the concept well enough and have explored it enough to start following signals on a small list of stocks and indexes that I follow.  To put it as succinctly as possible, Darknet looks for “several sets of regression channels to line up” in order to generate a trading signal.  The reason the name is Darknet is because the criteria used to generate the signals is not visible to the human eye just from looking at a standard bar chart.

In any event, following a “buy” signal I look for a call option to purchase using the “% to Double” routine at www.OptionsAnalysis.com.  The call option ostensibly is held until the system generates a “sell” (as in, exit a long position, not enter a short position). Since I only follow a handful of tickers there are not a lot of signals, but for illustrative purposes let me highlight a recent signal.

Ticker BIIB

Figure 1 displays three recent buy and sell signal generated by Darknet for ticker BIIB.  

Figure 1 – Darknet signals for ticker BIIB (courtesy www.OptionsAnalysis.com)

Let’s take a look at entering an option trade for the most recent signal at the far right hand side of Figure 1.  Figure 2 displays the output from the % to Double routine.  The first trade listed is the December 2013 240 call, which has 42 days left until option expiration.  A person who wanted to be more conservative could buy the third option listed – the January 2014 240 call option – which has 70 days left until option expiration.  

Figure 2 – BIIB Call trades ranked buy Bullish % to Double (courtesy www.OptionsAnalysis.com)

Let’s say we were willing to commit up to $2,500 to a trade and are comfortable trading the option with only 42 days left until expiration rather than the one with 70 days left.  The risk curves for this trade – buying 2 of the December 240 call – appear in Figures 3 and 4.  Figure 3 – BIIB December 240 Call (courtesy www.OptionsAnalysis.com) 

Figure 4 – Risk Curves for BIIB December 240 Call (courtesy www.OptionsAnalysis.com)

As with any long call position, the underlying security ultimately must rise in price in order for the trade to make money.  Also, time decay begins to accelerate in the month before expiration and this option has only 42 days left until expiration when the position is entered.  So the bottom line is that in this example, if BIIB does anything other than rally in the reasonably near future, the trade stands to lose money.

The Result

Well you didn’t think I was going to show you a losing trade, did you?  With a glance back at Figure 1 we see that BIIB rallied and that a sell signal was generated on 12/5/13.  At this point, the trade I highlighted could have been exited with a profit of +271.2% as shown in Figure 5.  Needless to say, not every trade works out as well as this one.  Still, it does grab one’s attention regarding the possibilities.

 Figure 5 – BIIB December 240 call at time of Darknet sell signal (courtesy www.OptionsAnalysis.com)

Don’t Forgot about Alternative Endings

In my analysis, the raw buy and sell signals from Darknet – in highly technical terms that we quantitative types like to throw around – “look pretty darn good” to me.  Of course, as with any trading method no trade or series of trades is certain to generate a profit.  So traders still must engage in the same old mundane and boring risk management (i.e., position sizing) and position management (i.e., when to exit with a profit, when to exit with a loss and when to consider adjusting a trade).

Which leads to one last point, remember that when you trade options you don’t necessarily have to “wait around for a sell signal.”  In many cases there can be opportunities to adjust an existing position in order to lock in profits and/or reduce risk.  As always, there are a lot of way to play.

If you are interested in receiving a Promo Code for www.OptionsAnalysis.com please leave a comment on my blog.

Jay Kaeppel

Focus is important.  Hey look, a squirrel!  OK, I’m sorry, what was I saying?  Well in any event, one thing I constantly tell people is that there has never been a better time to be a trader.  For one thing, the advent of ETFs has opened up a world of opportunity for investors and traders across a wide variety of investment categories.  In addition, options on ETFs allows traders to implement many strategies – and take advantage of  numerous opportunities – at a fraction of the cost involved in trading ETF shares themselves.

Ironically, the good news and the bad news for traders are one and the same.  The good news is that there are so MANY OPPORTUNITIES available now.  The bad news is that there are SO MANY opportunities available now.

Every day it seems like new ETF’s are coming out covering some even more arcane, previously not covered investment area.  You will know its peaked when they come out with the “Alphabet ETF Series”.  Can’t you see it coming?  For example:

*iProWisdomShareSPDRexion “A Name Fund” which trades every stock whose company name starts with the letter “A”.

*iProWisdomShareSPDRexion “A Ticker Fund” which trades every stock whose ticker name starts with the letter “A”.

(OK, in the interest of full disclosure I am sort of looking forward to owning a few shares of the “J” Fund)

So on and so forth until they get through “Z”.  Then come the leveraged, inverse and sector funds (Energy A, EnergyB, etc)……..The marketing people are staying up late my friends.

OK back to focusing:

To aid in the effort of helping traders to focus, please see the table in Figure 1 below.  There is really nothing earth shattering or ground breaking about this list, but it does provide a handy list of the ETFs in a variety of categories that have the most option trading volume.

If you narrow it down even more to just those tickers that are bolded, chances are you will find more opportunities than you can use.  The bottom line – if you can’t find some option trading opportunities here, you probably should not trade options.

Figure 1 – ETFs with active option trading volume

Remember, there are likely more opportunities available on this list than you can possibly use.

So let’s focus, people!

Jay Kaeppel

Please see my new article in Technical Analysis of Stocks & Commodities magazine titled “New Tricks With Old Indicators” (http://traders.com/) On Sale Now.

Please find below a complimentary link from MTA (Market Technicians Association) my webinar titled “Finding Exceptional Opportunities with ETF, Options and Seasonal Trends.

http://go.mta.org/watch112013

If there is one is universally true statement that I can make about trading systems in general and in specific, it is this – they sure are fun when they work.

When I first started trading – back in what I longingly refer to as the “Hair Era” in my life – I figured that I would be a “gut” trader – i.e., I was determined to rely on my keen instincts and intuitive reasoning to decide when to buy and sell based on current market conditions.

That was not fun.  After continually getting sucked into the swirling vortex of emotion – not to mention the abject fear associated with seeing  your money disappear – I found that I was getting the, um, back of my front so to speak, burned so many times that I was having difficulty, um, sitting down, so to speak.

Eventually I evolved into a systematic trader.  Now I am able to sit down much more often.  A few strategies that I have developed over the years have stood the test of time and become something of “bread and butter” strategies.  And they sure are fun when they work.  To wit….

Jay’s Pure Momentum System

In 2001, I published an article in “Technical Analysis of Stocks and Commodities” magazine titled “Trade Sector Funds with Pure Momentum”, which detailed one specific and simple trading method.  While in fact this is only one of many sector trading systems that I have developed over the years – and not necessarily the best one – it remains one of my favorites.  Probably because it is just so gosh darn simple.  When I was young my Momma told me to be a simple kind of man (or was it a Freebird she told me to be?).  Well, in any event, here are the “simple kind of rules” using Fidelity Select Sector funds:

-After the close of the last trading day of the month identify the five Fidelity Select Sector funds that have the largest gain over the previous 240 trading days.

-For this system, ignore Select Gold (ticker FSAGX).  If FSAGX appears in the top 5 funds then skip it and include the 6^th highest rated funds.

-If fewer than five funds showed a gain over the previous 240 trading days, then hold cash in that portion of the portfolio (i.e., if only 3 funds showed a gain, then 60% of the portfolio would be in those funds and 40% of the portfolio would be in cash).

-If you sell more than one fund at the end of a month, then rebalance the proceeds in the new funds being purchased (example, you are selling Funds A and B and buying Funds C and D.  You have $12,000 in Fund A and $10,000 in Fund B.  Split the difference and put $11,000 each into funds C and D).

And that’s all there is to it.

The Results

Figure 1 displays the annual results of this method. 

Figure 1 – Jay’s Pure Momentum Annual Results

Figure 2 displays the current portfolio.

Figure 2 – Jay’s Pure Momentum Current Portfolio

My opinion as to why this system has performed well over the years is, well – what else – simple.  The effects of a positive change in the fundamentals for a given industry or sector typically take a long time to play out.  Thus, by finding the sectors that are performing well you very often find the sectors that are most likely to continue to perform well for a while.

 Figure 3 – 12/31/13 Test (Courtesy: AIQ TradingExpert) 

Figure 4 – Several Current Sector Fund Holdings (Courtesy: AIQ TradingExpert)

Summary

Obviously 2013 was a banner year for this system.  There is nothing like a rip roaring bull market to help things along.  A couple of caveats:

*First off, sometimes people new to momentum investing will look at the charts in Figure 4 and say “Whoa, these things have already rallied sharply, I’m not jumping into those.”  That’s something you’ll have to get over to use this system.

*Secondly, while the long-term yearly numbers look pretty good, there was about a 45% drawdown along the way in 2008.  So it is not for the faint of heart.

*One other danger is that some people see +48.8% for the year in 2013  and get it in their head that this will occur again often.  History suggests otherwise. 

Still, an average annual return of +20.7% since 1990 (versus +8.9% for the S&P 500) isn’t bad – especially for a “Simple Kind of System.”

Best of Good Fortune in 2014.

Jay Kaeppel

Please see my new article in Technical Analysis of Stocks & Commodities magazine titled “New Tricks With Old Indicators” (http://traders.com/) On Sale Now.

The treasury bond market has showed a strong seasonal tendency to perform poorly during the early part of the year.  People often ask me “why” this would be so.  In fact I get that question often enough to make me wish I had a good answer.  Alas, as a proud graduate of “The School of Whatever Works”, I can only repeat our school motto, which is “Whatever!”

Two Early Year Trends in T-Bonds: Part 1

First let’s look at the performance of t-bond futures between the end of the first trading day of the new year and the 14^th trading day of February starting in 1978.  Figure 1 displays the performance achieved by an (extremely stubborn and not terribly astute) investor who held a long position in t-bond futures during this time period every year. Figure 1 – Long t-bond futures from on January Trading Day 1 through February Trading Day 14 (1978-present)

All told, the loss came to -$49,511 (excluding any slippage and/or commissions).  Of course, like all seasonal trends there is never any guarantee that the trend will hold true the next time around.  For the record the Jan TD 1 through Feb TD 14 period saw T-bonds:

-Gain 10 times

– Lose 25 times

-Breakeven 1 time

Each point movement in t-bond futures is worth $1,000

-The median gain during up years was +$2,234

-The median loss during down years was -$2,406

-The largest gain was $6,937 in 2000.

-The largest loss was -$15,281 in 1980.

So basically, t-bonds gained 28% of the time, and lost or broke even 72% of the time, and the median loss was slightly greater than the median gain.

Two Early Year Trend in T-Bonds: Part 2

Let’s look next at the net performance for t-bonds during the first four months of the calendar year.  Typically, after bonds sink into mid-February there is a bounce in the second half of February.  But for our test we will just consider the results achieved by holding a long position in t-bonds from December 31^st each year through the end of April.  These results appear in Figure 2. Figure 2 – Long t-bond futures December 31^st through April 31st

All told, the loss came to -$66,389 (excluding any slippage and/or commissions).  Of course, like all seasonal trends there is never any guarantee that the trend will hold true the next time around.  For the record the Dec 31^st to Apr 30th period saw T-bonds:

-Gain 16 times

– Lose 20 times

Each point movement in t-bond futures is worth $1,000

-The median gain during up years was +$1,797

-The median loss during down years was -$4,813

-The largest gain was $13,968 in 1986.

-The largest loss was -$11,313 in 1994.

In reality, the January through April time frame has seen t-bonds show a loss only 56% of the time.  So this trend is absolutely by no means a sure thing, so the one thing you should absolutely not do is get it in your head that t-bonds are bound to decline between now and the end of April.

The key thing to note regarding this trend is that the median “down” year has witnessed a decline that is 2.7 times larger than the median gain shown during the “up” years.  So the key is simply to recognize the potential danger.

Summary

With t-bonds presently quite oversold, it is a little difficult to jump on the bearish bandwagon at the moment (in fact, bonds are rallying nicely as I write here on the first trading day of the year).  And as I have tried to make clear, a decline in t-bond prices during either of both of the highlighted periods is by no means a sure thing.  Still, this little bit of history suggests that getting wildly bullish on t-bonds may not be the best strategy.

Jay Kaeppel

Please see my new article in Technical Analysis of Stocks & Commodities magazine titled “New Tricks With Old Indicators” (http://traders.com/) On Sale Now.

Well it’s almost 2014.  Time for my annual stock market prediction.

Yah, right.  Sorry, I don’t do predictions.  Actually, for the record I do, but only in my head – for fun.  So you’ll just have to take my word for it that my “predictions track record” isn’t too good.

Now that may sound like a startling self-deprecating admission, but the reality is that I have a tremendous amount of company –made up of people who actually do make predictions “out loud.”

Let me be clear on how I see it: Predictions are a waste of time.  Trends are what matters. At the moment it would be impossible to argue that the trend of the stock market is not “up.”  So that is the way to play until shown otherwise.

But there are other trends we can also consider in terms of looking ahead.

The Mid-Term Election Year

To put it as succinctly as possible, the mid-term election year has historically been something of a mixed bag.  The good news is that the market has showed a tendency to achieve a “major bottom” during mid-term election years.  The bad news is that many of those major bottoms were preceded by the requisite “major decline” leading up to said “major bottom.”

The other piece of good news is that most of the “bad stuff” has historically been worked out by the end of September.  To illustrate all of this consider the Figures below.

Figure 1 displays the growth of $1,000 invested in the Dow Jones Industrials Average – which can now be achieved by buying a Dow index mutual fund or ETF such as ticker DIA – during every mid-term election year starting in 1934.

Figure 1 – Growth of $1,000 invested in the Dow Jones Industrials Average every mid-term election year since 1934

For the record, $1,000 invested in the Dow only during every mid-term election year since 1934 grew to $2,841.

Now in Figure 2, we break each mid-term election year down into two periods:

Period 1 = January through September

Period 2 = October through December

As you can see, there is “a difference.”

Figure 2 – Growth of $1,000 invested Jan-Sep of mid-term election years (blue line) versus growth of $1,000 invested Oct-Dec of mid-term election years (red line); 1934-present

Here is how it breaks down:

January through September of Mid-Term Election Years = $1,000 declined to $684 (-31.6)

October through December of Mid-Term Election Years = $1,000 grew to $4,154 (+315.4%)

 Summary

So should we “sell everything” and “stuff our money in our mattresses” and “come back in October?”  Well, not necessarily.  As I mentioned at the outset, the trend of the market is presently “up”.  But history suggests that 2014 will not be quite the “smooth sailing” that was 2013.

So for now the tentative game plan is:

-Stick with the trend

-Be alert for changes in the trend (have you noticed there has been a lot more “happy talk” lately – i.e., after the fact justification of why the market is up and how everything will start getting better real soon?  The more you hear that talk, the more alert you need to be).

-Be ready to be in the market after September 30^th, 2014.  No matter how things look at that time.

 Addendum

OK, I will make one prediction for 2014 – and I have to say that I have been spot on with this one in the past:

The Cubs WILL NOT win the World Series in 2014.

I’m feeling pretty confident about this one….

Jay Kaeppel 

Please see my new article in Technical Analysis of Stocks & Commodities magazine titled “New Tricks With Old Indicators” (http://traders.com/) On Sale Now.

Some seasonal trends have shown a tendency to persist through time (hence the use of the word “trend”, I guess).  As it turns out we are at the cusp of one of “those times” right now.  It is sitting there like a wrapped gift under the tree with our name on it – so let’s not waste any time diving in.

December-January Changeover

The period we will look at encompasses the last 4 trading days of December and the first 3 trading days of the following January.  In other words, a contiguous 7 day trading period during which the stock market has showed a tendency to behave in a bullish manner.

Now given the persistence of the recent market run up, many may be a little leery of diving in here.  Which I understand.  Still, the numbers are what they are, so let’s take a look.

The Test

So as not to make it easy on ourselves, this test begins in December 1933, i.e., in the early days off the great Depression.  We will buy the Dow Jones industrials Average at the close of the fifth to last trading day of the year and sell at the close of the third trading day of January. This test assumes no interest is earned while out of the market so that we measure only the performance during the supposedly bullish period.

The Results

Figure 1 displays the growth of $1,000 invested in the Dow every year since 1933 during the seven trading days just described.  Figure 1 – Growth of $1,000 invested in Dow Industrials during bullish 7-day period (1933-present)

Two anecdotal comments from a quick perusal of the graph in Figure 1:

-There is clearly a lower left to upper right trend, which is what we want to see in any equity curve

-It is by no means “perfect”, so a little closer analysis of the numbers may be useful in convincing ourselves that this trend might actually be useful.  So in order to gain some perspective, let’s compare the performance of the Dow during this time period versus Dow performance for all trading days.

A few figures of note:

-System average daily performance is +0.22% versus +0.03% for all trading days (7.53 times greater).

-System median daily performance is +0.17% versus +0.03% for all trading days (4.00 times greater).

-338 out of 560 system trading days showed a gain (60.4%).

-10,946 out of all 20,922 trading days showed a gain (52.3%).

-Average 7-day return only during system days = +1.55%.

-Average 7-day return for all trading days = +0.20%.

-The 7-day system period has showed a gain in 62 of the past 80 years (or 77.5% of the time)

One other thing to note is that returns (and albeit risk) is enhanced by trading leveraged funds such as ticker UDPIX (Profunds UltraDow) or UDOW (ProShares UltraDow30 ETF).

 Summary

So is the Dow destined to be higher at the close on January 6, 2014 than it was at the close on December 24^th, 2013?  Not necessarily.  But that would seem to be the way to bet.

Jay Kaeppel

This article presents another twist to the one I posted a few days ago titled “A Trader’s Guide to Buying the Dips” (http://jayonthemarkets.com/2013/12/13/a-traders-guide-to-buying-the-dips/).  This article presents a variation known as “Jay’s Pullback System”

First let’s look at the building blocks:

A = S&P 500 daily close

B = 10-day simple moving average of S&P 500 daily close

C = (A – B)

Buy Signal = Variable C declines for 3 or more consecutive days

In a nutshell, if the difference between the S&P 500 index (SPX) and its own 10-day moving average declines for 3 straight days we consider this to be a “pullback”, and thus a buying opportunity.

Trading Rules for Basic System:

When Variable C declines for 3 straight days, buy and hold the S&P 500 Index for 5 trading days. If the decline in Variable C extends itself one or more days, then extend the holding period for that many trading days.

So for example, if Variable C declined for 5 straight trading days, one would buy at the close of the third trading day and then hold for seven trading days

Day        Variable C            Action                                                                                   Position

1              Down

2              Down

3              Down                    Buy at close (hold for 5 days)

4              Down                    Hold (Var. C down again; hold for 5 days)              Long

5              Down                    Hold (Var. C down again; hold for 5 days)              Long

6              Up                          Hold (for 4 days)                                                               Long

7              Down                    Hold (for 3 days)                                                               Long

8              Up                          Hold (for 2 days)                                                               Long

9              Down                    Hold (for 1 day)                                                                 Long

10           Up                          Sell at close                                                                         Long; Flat at close

Figure 1 displays “bullish days for SPX in green.  In the lower clip we see the difference between the close and the 10-day moving average (i.e., Variable C).  A “bullish” period is signaled when that value declines for 3 straight days  Figure 1 – Basic System bullish days for SPX (Courtesy AIQ TradingExpert)

 Results:

This is a very rudimentary “system” and not suitable for many traders (note this raw system includes no stop-loss provision and does not attempt to filter for and trade with the major trend).

In any event, let’s look at what would have happened if one had followed the rules and held the S&P 500 for 5 trading days following every decline in Variable C of 3 days or more, and earned 1% of annual interest while out of the market.  Those results are displayed (along with the growth of $1,000 achieved by buying and holding the S&P 500 Index) in Figure 2.Figure 2 – Simple Pullback Systems (blue line) versus Buy and Hold (red line) Dec 1987 to present

Results:

-$1,000 invested using this system grew to $13,249 (+1,225%)

-$1,000 invested using buy-and-hold grew to $7,208 (+621%)

So we can reasonably state that these results are pretty good.  Can they be improved? Let’s see.

 Jay’s Pullback System

With this system we will filter for the trend and at times use leverage.

First we will note if the daily close for the S&P 500 Index is above or below its own 250-day moving average.

If Variable C above declines in value 3 straight days:

-If SPX > 250-day moving average we will buy using leverage of 2-to-1

-If SPX < 250-day moving average we will buy using no leverage

-Interest of 1% per year will be assumed when out of the market.

The results of this test appear in Figure 3. Figure 3 – Jay’s Pullback System: Growth of $1,000 (blue line) versus buy and hold (red line; Dec 1987-present

Results:

-$1,000 invested using Jay’s Pullback System grew to $44,541 (+4.354%)

-$1,000 invested using buy-and-hold grew to $7,208 (+621%)

Funds to Use

Mutual Fund: Profunds ticker BLPIX (S&P x 1)

Mutual Fund: Profunds ticker ULPIX (S&P x 2)

ETF: Ticker SPY (S&P 500 x 1)

ETF: Ticker SSO (S&P 500 x 2)

Summary

While the numbers for the leveraged system look pretty good, it should be noted that there are no stop-loss provisions incorporated.  Before you decide to run off and trade any system – particularly one that may use leveraged funds or ETFs, you ought to do some homework and make sure you fully understand and can tolerate the risks involved.

Still, the real point of all of this is simply to note that buying on dips is a valid approach to trade the stocks markets.

Jay Kaeppel

Please see my new article in Technical Analysis of Stocks & Commodities magazine titled “New Tricks With Old Indicators” (http://traders.com/) On Sale Now.

The S&P 500 has declined for three consecutive days.  Should you care? Well, perhaps.  In Figure 1 we see the growth of $1,000 achieved as follows:

-When the S&P 500 registers 3 (or more) consecutive lower closes, buy and hold for the next 5 trading days.

To be clear, the results shown here assume that you buy at the close of the 3^rd consecutive down day and plan on holding a long position in the S&P 500 for the at least the next 5 trading days.  This holding period is extended one day for each additional day the S&P declines consecutively.  In other words of the S&P 500 declines for 5 consecutive days, you would buy at the close of the 3^rd consecutive down day and hold for 7 trading days.

Not sure of that explanation helped or made things more confusing but there you have it. Figure 1 – Growth of $1,000 invested in S&P 500 after 3 (or more) consecutive down closes (December 1987 to present)

In this test, an initial $1,000 grew to $9,869, or +887% (no slippage, commissions, taxes, dividends, interest, etc., just raw price return), with a maximum drawdown of -19.3%.

Filtering for Trend

One of the dangers of this approach is the “Are You Sure You Want to Try to Catch that Falling Safe?” conundrum.  So what happens if we only take the trades that occur when the S&P 500 is in an established uptrend?  If we only take the trades that occur when the S&P 500 is above its 250-day moving average we get some Bad News and some Good News.

The Bad News is that $1,000 grows to $3,935, or +293%.  So clearly a lot of profit potential left on the table.

The Good News is that the maximum drawdown using this method is only a very manageable -9.8%. Figure 2 – Growth of $1,000 invested in S&P 500 after 3 (or more) consecutive down closes (December 1987 to present) only when S&P 500 is ABOVE its 250-day moving average

Using Leverage

Figure 3 displays the growth of $1,000 using the following assumptions:

-If the S&P 500 declines 3 or more consecutive days AND the S&P 500 is BELOW its 200-day moving average, buy and hold the S&P 500 index for 5 trading days

-If the S&P 500 declines 3 or more consecutive days AND the S&P 500 is ABOVE its 250-day moving average, buy and hold the S&P 500 index using leverage of 2-to-1 (via a leveraged ETF or mutual fund) for 5 trading days

-For this test we assume that an annualized rate of 1% interest is earned when no position is held.

In a nutshell, if the stock market is in an objectively identified up trend (i.e., close above 200-day moving average) we will attempt to press our advantage by using 2-to-1 leverage.   When the S&P 500 is below its 250-day moving average we will eschew the use of leverage.

The results for this test appear in Figure 3. Figure 3 – Growth of $1,000 invested in S&P 500 after 3 (or more) consecutive down closes using 2-to-1 leverage if S&P 500 > 250-day moving average (December 1987 to present)

Using this approach $1,000 grew to $35,868, or +3,469% (albeit with a maximum drawdown of -20.2%).

 Funds to Use

Mutual Fund: Profunds ticker BLPIX (S&P x 1)

Mutual Fund: Profunds ticker ULPIX (S&P x 2)

ETF: Ticker SPY (S&P 500 x 1)

ETF: Ticker SSO (S&P 500 x 2)

Summary

Does this simple method represent the “Holy Grail of Trading?”  Of course not.  Is it even better than whatever system you are using right now?  I can’t answer that, only you can.  But the main point here is simply to note that dips in the stock market – even in the face of an overall downtrend – tend to be buying opportunities (at least in the short run).

The simple rules presented here represent just one way to exploit this fact.

Jay Kaeppel