Profiting from Intermediate Market Swings

A framework to implement medium-term strategies and hedges overlayed on an active, long-term index ETF portfolio, that is constructed using the concepts of the Meta Strategy.

Many long-term investors, who closely follow the markets, tend to be frustrated by the regular „3 steps forward – 2 steps back“ behavior the market displays the majority of the time. This often leads to the urge to profit from these medium- or short-term fluctuations. Most of the higher quality financial research strongly discourages such market timing behavior and one tends to quickly enter the realm of trading strategies, that provide positive value to only a very small percentage of active traders (the most common statistic across studies is, that 95% of active traders lose money over time).

Nonetheless the urge to beat the market is a strong incentive and many market participants, me included, spend considerable time and efforts to find sustainable edges – it is quite a mesmerizing endeavor.

Because, I believe, that long-term, active investing is the right approach for my personal portfolio, I spent some time developing a sophisticated model to navigate the long-term market movements between bull and bear markets – between economic expansions and recessions. Harvesting risk premia (especially the equity risk premium) over time while avoiding the behavioral traps many investors tend to fall into by implementing a tactical asset allocation to avoid the worst bear markets, has turned out to be the right solution for my core portfolio.
As this model aims to be fully invested in equities (via an index ETF) most of the time, it sits through market corrections that are smaller than approximately -15%.

Dissatisfied with the times the market essentially goes nowhere for long periods of time, I use a combination of two essentially opposing strategies as an overlay on top of this tactical ETF portfolio to generate additional returns over the medium-term (up to 30% to 40% of capital could be invested in this alternative sleeve).

The time frame is essential

Through extensive research into the different types of edges the market provides, I come back to two basic factors that come up again and again as a reliable basis for different investment strategies: momentum and carry (profits made when prices do not change e.g. time decay in short options, dividends, interest on bonds etc.) – which are based on trend and mean-reversion.

Painful experience has taught me, that in the short-term realm many edges become very small and noisy or vanish altogether. I think, that it is important that every investor and trader finds an environment that fits his personality and have decided for myself to stay away from time frames below one week.

Over longer time horizons, however, academic studies paint a much clearer picture of which force tends to dominate in the market:

  • around 1 month: mean reversion dominates
  • 2-15 months: momentum works
  • 3-5 years: mean reversion kicks in again

My core portfolio operates on the premise, that equities pay the highest premium over time, unless the economy shrinks (i.e. a recession) and equity prices change their direction to break their long-term uptrend.

But market prices oscillate considerably around these long-term market movements in patterns that are largely random, but display strongly mean-reverting properties on the medium-term time frame around one month. Randomness makes it impossible to time these fluctuations exactly, but I am quite comfortable to gradually adjust exposure to my alternative strategy sleeve during these medium-term swings – buying low and selling high.
That is – just as long as I have safeguards in place in case of overextended moves and each strategy has a superior return expectation on its own over time.

Alternative strategy sleeve

My basic rule here is to do no harm – I only ever use strategies that have shown to outperform the S&P 500 historically with a minimum of rules and parameters.

Shorting volatility is one return-enhancing strategy, that I have written about quite a few times and have used in my portfolio for many years: it essentially adds the volatility risk premium to the equity risk premium. This premium is high and persistent over time, because it is based on market participants willingly paying someone to take the risk of an equities crash off their hands – many investors want to insure their portfolio even if the price to do that is quite high. 

Short vol outperforms most in the smooth, uninterrupted up-moves, that cause volatility to collapse from short spikes – we often see these on the intermediate time horizon (three smooth steps forward).

There are many ways to implement short vol strategies – most use options or VIX futures. 
I find one implementation suited particularly well to ride intermediate market swings: Buying VXX or UVXY put options. These two volatility ETP bleed constant value over time making a put option strategy viable – a „dumb“ strategy, e.g. buying 3-month UVXY ATM puts every quarter, will make money over time (usually buying options is not an inherently promising strategy as the premium eats up most of the return).
In this case the return reducing premium we pay can be viewed as a re-insurance against the rare, but violent losses that short volatility strategies are prone to (they insure other people’s catastrophic risks after all). We bet on fairly regular fluctuations and rising equity prices while insuring ourselves against sudden crashes and volatility spikes. In contrast to outright short volatility positions (e.g. short VIX futures), that carry unlimited downside risk, the most we can lose here is the premium we paid.

The 1,5x leveraged long VIX futures ETF UVXY bleeds value over time and put options provide an opportunity to profit from this tendency, while providing a ceiling to the risk of volatility spikes: losses are limited to the cost of the put option, while possible gains are unlimited. (Source: Yahoo! Finance)

As with all long option positions the downside is the time decay we face as a headwind – if the underlying ETP does not change in value, the option slowly loses value every day.
This time factor is a compelling reason for me to adjust position sizes through medium-term market fluctuations: when volatility rises (the stock market corrects), I add positions incrementally, when it falls I take profits at predetermined levels.
Because the strategy is profitable over time without any attempts at market timing, it is quite robust to a wide range of attempts to introduce discretionary or systematic timing alpha – whether you use fibonacci levels, oversold conditions indicated by an oscillator like RSI or simply a certain amount of movement in the S&P 500 or the VIX itself.

I always want to see two basic conditions met before buying UVXY puts, as I have found them to greatly enhance the basic strategy over time: 

  1. the S&P 500 is in a longterm uptrend (e.g. above its 200-day moving average), because a majority of vol spikes occur in a downtrend and 
  2. the VIX Futures Term Structure is in contango as this is the basic condition that makes VXX and UVXY lose value even when the VIX itself does not change.

Other than that, I like to start buying at-the-money put positions with plenty of time to expiration (about 4-6 months), whenever VIX rises from a relative low (e.g. below 13) by about 15% to 20%. This very simple idea may be added to by looking at the 60-day moving average of the S&P and areas that promise support.
I then split my overall position into three parts to enter incrementally during the move to and/or from a relative low in the S&P 500. It is very important to size the position properly – which is relatively easy: your whole position size should be equal to the maximum loss you are willing to take from time to time (from my own practical experience and backtests losses between 50% to 100% of the put value occur roughly 20% of the time).
My initial profit target is set at 30% and I often let part of the position run longer to sell into a medium-term top in the S&P 500.

While buying and selling these UVXY puts I simultaneously decrease and increase a hedge for the core ETF position in my portfolio.

Hedging is a form of insurance of your portfolio value and can therefore be expected to cost money over time – in fact many studies point to the fact that buying puts (the most common form of hedging), to protect your portfolio, costs more in return than simply reducing overall portfolio exposure would have. I usually take the other side of this trade with the short vol strategy above and only consider buying S&P 500 puts when a move becomes abnormally extended to the upside and a correction seems increasingly likely.

Covered call writing
There is one strategy however, that has hedging properties and the characteristic to improve long-term returns at the same time: writing covered call options.

The Cboe S&P 500 BuyWrite Index (BXM) shows that continuously writing covered calls on a S&P 500 ETF portfolio enhances return and especially lowers volatility by about 30% (Source: CBOE).

I use the opposite methodology as with the UVXY put strategy above: whenever I sell a UVXY put at a profit target, I also sell a call option on the S&P 500 ETF in my core portfolio, that hedges its downside by the amount of premium I get paid. This hedge is easily scalable – I am fairly aggressive and like to over-hedge during a considerable market rise: 

  • on a new high in the S&P, I sell a covered call on half of my ETF position
  • at the next level (about 1 ATR S&P 500 higher), I write another call and am net long by the remaining UVXY put I still own
  • at the next level all UVXY puts are sold and through adding another short call my exposure is now slightly net short while I wait for the next small correction, meanwhile profiting from the call´s continuous time decay.

Limitations of covered calls
The downsides (there is no free lunch!) of using covered short calls as a hedge are, that the protection is limited to the option premium you are paid and that the profit potential of the core ETF portfolio is capped at the strike price of the call options. These limitations sound unappealing, but actually make a covered call strategy one of the few hedging strategies, that have a superior net positive return expectation (the core premise each single portfolio strategy has to fulfill for me).
In my experience the profit cap included in the hedge is more than made up by the superior performance of the short volatility strategy: when the market rises in an uninterrupted streak, the short calls neutralize any further gains of the ETF portfolio beyond a certain point, but such phases are especially lucrative for short volatility strategies.
An example would be the end of 2017 – and even that historically unprecedented streak of a low volatility market rise without any setbacks eventually corrected violently and temporary losses in the hedging positions were recovered.

The limited protection of the hedge is accounted for within my overall portfolio framework, because the Meta Strategy ETF portfolios include a stop loss mechanism, that reduces stock exposure when a larger market downturn materializes to protect against bear markets.
The hedge´s function is limited to dampening intermediate market swings and gain some extra performance during the normal „3 steps forward – 2 steps back“ behavior of the market – against major trend changes I am protected by adjusting the equity exposure in the portfolio overall.

I hope this gives some food for thought and wish you successful investing!

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