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The Philadelphia Semiconductor Index – most commonly referred to as the SOX Index, or even more succinctly as SOX – is an index that tracks a basket of semiconductor stocks. As you might guess, the SOX Index is quite volatile. From the perspective of a trader, volatility is not necessarily a good or bad thing. If something moves frequently in great magnitude, this simply implies that there are both great risks and great potential rewards. A good trader will focus on trying to find ways to maximize the latter while minimizing the former.

Another interesting thing to note about the SOX is that – not surprisingly – it has a very high correlation to the tech-heavy Nasdaq 100 Index. The four-year correlation coefficient is approximately 0.75 (a correlation of 1.00 would indicate that the two indexes trade in tandem). So an obvious question might be, “Is there a way to take advantage of this high volatility and high level of correlation with the Nasdaq market?”  Would I be mentioning it if I thought there were not?

A few foundational points:

The SOX itself is not tradable as an index (although options are available) so we need another vehicle to trade which closely tracks the SOX Index. For our purposes we will use Rydex Electronics (RYSIX), which has a four year correlation of .944 with the SOX Index (an alterative would be the exchange-traded fund SMH). Secondly, in our test we will want to compare the performance of RYSIX with the inverse of the Nasdaq 100. To achieve this we will use Rydex Arktos (ticker symbol RYAIX) which trades inversely to the Nasdaq 100 (in other words, if the Nasdaq declines 1% RYAIX should rise 1%).

In Chart 1 you see the ratio of the price of RYSIX divided by the price of RYAIX on a daily basis since 12/31/1998. At the far left you see the tech bubble culminate in 1999-2000 followed by an equally steep narrowing of the historical ratio. Since that time, the ratio has fluctuated in a much more narrow range.  

Chart 1 – RYSIX/RYAIX Ratio 12/31/98 through 8/4/08
(click here for larger view)

In most cases it would make most sense to try to ride the trend of this ratio. In other words, intuitively it would seem logical to own Electronics when the ratio is in an uptrend (however that may be defined) and to be in cash or in RYAIX (i.e., short the Nasdaq 100) when the ratio is in a downtrend (however that may be defined). However, no matter what I tested I never came up with very good results. So it soon became time to “think outside the SOX."

What I came up with is a very short-term countertrend trading method. It goes like this:

A = RYSIX daily closing price
B = RYAIX daily closing price
C = A / B (i.e., RYSIX divided by RYAIX)
D = 3-day exponential moving average of C
E = C – D (i.e., today’s ratio minus today’s 3-day exponential moving average)

As you might guess (assuming of course that you have the slightest idea what the hieroglyphics above actually mean), the value for E fluctuates constantly above and below 0 since we are using such a short-term moving average.

Rather than buying RYSIX when it is gaining strength relative to RYAIX (i.e., when E is above zero) and vice versa, we will in fact do just the opposite as follows:

-If today’s value for variable E is greater than zero, then at tomorrow’s close we will sell RYSIX (i.e., exit semiconductor/electronics stocks) and buy RYAIX (i.e., sell short the Nasdaq 100).

-If today’s value for variable E is less than zero, then at tomorrow’s close we will buy RYSIX (i.e., purchase semiconductor/electronics stocks) and sell RYAIX (i.e., exit a  short the Nasdaq 100 position).

The good news is that the results are pretty good especially considering that between 12/31/1998 and 8/4/08 RYSIX lost -22% and RYAIX lost -45% (albeit with some huge swings along the way). A $1,000 investment on 12/31/1998 split equally between RYSIX and RYAIX would have shrunk -33% to just $666 by 8/4/2008. At the same time, $1,000 invested using the method I just detailed above would have grown to $27,303, or 2,630% during the same time. The stark contrast in results is depicted in Chart 2.

Chart 2 – Growth of $1,000 using RYSIX/RYAIX strategy (blue line) versus growth of $1,000 splitting $1,000 between RYSIX and RYAIX on a buy-and-hold basis (brown line) since 12/31/1998

Summary

As you can see in Chart 2, the equity curve for the RYSIX/RYAIX method is not without large swings and occasional sharp drawdowns, which brings up something important regarding the use of any mechanical trading method—that being the likelihood that you will actually enjoy the results indicated by the historical results. If I were simply to mention that the method gained +2,600% versus -33% for buy-and-hold and just left it at that, a great deal of interest might be piqued. However, to get a more realistic picture one must also consider that the maximum drawdown was -47% and that there were three other drawdowns in excess of -30%. Also, this method requires absolute daily monitoring since switches occur with great frequency (833 trades since 12/31/1998, including 53 alone since 12/31/2007).

A lot of individuals just lost interest based on those simple factoids. And that is not necessarily a bad thing. If stomaching large drawdowns in pursuit of outsized gains (+49% per year since 1998) is not your thing, or if frequent monitoring and several trades a week is more than you are prepared to commit to, then in reality you should not consider trading a method such as this one. As always, this method is not a trading recommendation. It is simply an illustration of the possibilities that exist if you are willing to – Okay, one more time – think outside the SOX. If your interest is piqued, I encourage you to do your own testing before diving in.     

To search for previous articles written by Jay Kaeppel, please click here.

Jay Kaeppel
Staff Writer and Trading Strategist
Optionetics.com ~ Your Options Education Site

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