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Karel Ondriash
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Private investor since 2005. Prior to that, Karel Ondriash managed Software Engineering Department at CNET Channel, currently a division of CBS Interactive Inc. He holds a PhD in Physics and Mathematics from General Physics Institute, Russian Academy of Sciences. Karel Ondriash currently lives... More
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  • Trading An Index-Tracking ETF/Inverse ETF Pair May Yield Solid Results

    Trading a pair of ETFs - index-tracking ETF and inverse ETF - seems to be very suitable approach for those seeking investment opportunities in every market environment. Indeed, irrespective of what the market's general direction is, an investor may easily participate by simply buying shares of the corresponding ETF. One of the most popular ETF is S&P 500 SPDR (ticker symbol SPY) tracking performance of the S&P 500 Index. It has about $100 billion in assets under management and trades more than 100 million shares on an average day. To compose a trading pare, one may consider, for instance, the first inverse ETF ProShares Short S&P 500 (ticker symbol SH). According to its prospectus, "the Fund seeks daily investment results, before fees and expenses, that correspond to the inverse (-1x) of the daily performance of the Index". Though this ETF is much smaller in size, it still possesses very respectful figures: more than $1.5 billion in assets and several millions shares changing hands every day. Thus, both ETFs provide more then enough liquidity for a vast majority of individual investors.

    It's a common knowledge that proper timing is a key to investing success. However, this can be especially true in a volatile market like we observe nowadays. To produce timing signals for trading the pair of index-tracking/inverse ETFs, a combined methodology (CM) has been developed. It involves the following methods:

    • Point&Figure (P&F) analysis of the S&P 500 Index;
    • Using William J. O'Neil's concepts to define market bottoms and market tops by looking for follow through days and analyzing distribution respectively;
    • Applying some classical indicators like Moving Averages, Slow Stochastic Oscillator and Bollinger Bands.

    Each method delivers its specific contribution to the CM. For instance, P&F analysis is known for eliminating insignificant price movements, thus helping to identify the trend. Analyzing distribution often allows spotting market weakness in a timely manner, etc. As both methods still generate false signals from time to time, applying classical indicators in addition to them is beneficial to the overall performance. Of course, this gives just a brief idea of how the CM works; its real implementation is a rather complex rule-based system.

    The combined methodology has been back-tested over the period since January 2008 till mid of November 2012 (i.e. over almost 5 years). During this period the market passed through several very different phases. First, after marking a multi-year high in October 2007, the market started relatively slow drifting downside in the first half year of 2008. This was followed by the Leman-induced market crash in September 2008 and sharp decline in subsequent several months. A turnaround that happened in March 2009 has ignited a new bull market. Though the bulls experienced some difficulties in the summer of 2010 and in the summer of 2011, the market managed to reach new multi-year high in September 2012. Thus, the period under consideration looks to some extent as a model of the market cycle.

    A pair of ETFs consisted of the already mentioned SPY and SH. While calculating possible outcome, timing signals were considered to be generated on the basis of the post-market analysis. If a timing signal arose, a market order to buy/sell shares of the appropriate ETF was simulated before the next day market open. Thus, the shares were always considered to be bought/sold at the market opening price.

    Fig.1 illustrates how the hypothetical $1000 investment could have fared if it has been deployed in January 2008 and then was managed consistently according to the timing signals generated by the CM. A cumulated result since January 2008 till mid November 2012 totals about 500%. This corresponds to an average annual growth of approximately 38% during 5 years. No trading fees were being taken into account. However, as the number of trades averages just about 7-9 per year (see Tab.2 below), the profit reduction accounted by trading fees can be treated as being negligible.

    Fig.1 Value of the hypothetical $1000 investment if it was invested according to the proprietary market timing signals since January 2008.

    Each point represents value of the investment after market close.

    (click to enlarge)Fig.1

    Due to the inverse component, the CM delivered strong gains in 2008, when the stock market crashed. In 2009, the CM overtook S&P 500 by a wide margin as the inverse component enabled it to catch the rest of the downside move while participating in the index-tracking ETF ensured benefiting from the market's rebound from its very beginning. In 2010, the CM navigated smoothly through the summer volatility that followed the so-called Flash Crash. A year later, the CM correctly handled both the sharp decline in August and the subsequent strong rally. Current year is probably the most challenging period for the CM so far. Stop-losses have been activated several times recently. This helped to avoid losses, but on the other hand some profits have been missed too. Still, as for November 16, the CM overtakes S&P 500 by about 10 %.

    The following table provides a comparison of the combined methodology performance versus S&P 500.

    (click to enlarge)

    Tab.2 shows some statistics that may be of interest while considering the CM's effectiveness. The number of completed trades averages about 7-9 per year, with the highest number of completed trades - 9 - in 2008 and the lowest number - 7 - in 2009 and 2010.

    (click to enlarge)

    Finally, Tab.3 presents all timing signals generated by the combined methodology during the back-testing period (i.e. since January 2008 till mid of November 2012). BUY signal for the index-tracking ETF sometimes comes simultaneously with SELL signal for the inverse ETF and vice versa. The table gives also an idea on amount of gains/losses in particular trades.

    Tab.3 All timing signals since January 2008 till mid November 2012.

    Conclusion: A combined methodology has been developed that produces market timing signals basing on the post-market analysis of the S&P 500 Index. The methodology was back-tested in application to trading a pair of ETFs - index-tracking ETF and inverse ETF . A cumulated result since January 2008 till mid of November 2012 totals about 500%. This corresponds to an average annual growth of approximately 38% during 5 years.

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

    Nov 20 1:41 AM | Link | 3 Comments
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