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The Perfect Strategy?

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There is no such thing as a golden ticket or a magic bullet when it comes to investing strategies but it is possible to seek better performance, strategies, etc. The following system constructed by CXO Advisory Group is intriguing because it seeks to exploit multiple stock market 'anomalies'. The anomalies identified by CXO (and others) are the following (please visit CXO for extensive documentation and citations):

  • Size - Small cap stocks tend to do better over long periods of time
  • Value - High book to market stocks tend to outperform
  • Volatility Risk Premium - In other words, volatility tends to be priced into options higher then the actual volatility. Thus, CXO seeks to 'exploit this premium by repetitively selling near-term, near-the-money options.'
  • Turn-of-the-month - Stocks tend to perform better at the end of the month.
So what's the strategy? Take a small cap value (points 1 and 2) ETF like IWN or IWM, sell slightly out of the money calls or puts near the end of the month. Repeat, monthly. CXO revised the strategy in April 2009 to focus solely on selling puts on the Russell 2000 Index (not an ETF, but the actual index).

Sound complicated? CXO updates and tracks the strategy monthly so you can follow along. I have added a link on my blog under ETF and Timing Strategies on the right hand side. The most recent trade:

8/25/09: Sell to open RUWUN Russell 2000 Index puts expiring September 18, 2009 at strike price 570 (2.3% out of the money) against the account cash balance (rounded to the nearest number of contracts).

Please note: Neither I nor CXO are recommending this strategy to anyone. Options carry added risk so please, please do not try this at home unless you know exactly what you are getting into. That being said, that's part of the point of part 3 - the volatility risk premium tends to pay those people who want to take the risk.

I currently do not hold a postition in any of the stocks mentioned. I may employ this straregy in my personal account at some point in the future.