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One significant challenge facing traders is managing shorter-term positions while holding longer-term assets. The buy and hold days that were embraced in the past made this task a lot easier (invest and don't think about it), but 2008 likely changed the way many traders view their longer-term investments. A first step towards simultaneously managing long-term and shorter-term assets involves the completion of a few basic personal finance tasks, including allocating assets for each then specifying time horizons.

A complete trading plan will map out how both investments and trading assets are managed including information regarding:

• Markets and securities used
• Frequency of your routine and tasks included
• Methods applied for entering/exiting positions
• Analysis forms used (technical, fundamental, blended, ")
• Different time horizons considered for shorter-term assets
• Approach focus (directional, volatility, ")

These elements may be more familiar to Cornerstone users who focus completely on creating their own plan. Assuming equities represent a portion of your longer-term investments, you need to assess whether or not you subscribe 100% to a buy and hold method for those assets. If you do not, you may want to start by specifying an allocation range for equities and identifying what circumstances results in being invested at the lower end of the range or higher end of the range.

The Platinum Toolbox and Analytical Toolbox articles in November and December of this year focused on longer-term systems geared towards protecting assets during market downturns. The two techniques tested in an attempt to meet this goal include market timing using simple moving averages and hedging holdings with long puts.

Even after narrowing the techniques down to two, the tests barely scratch the surface of what's available to option traders. With that in mind, the articles are intended to serve as a launching point to help you find methods that best suit your individual trading style, preferences and constraints. By making it your own through analysis, testing and assessment, you will emerge with an approach that can be implemented and refined for many years.

A basic description of the different approaches used is provided next. For more detail, please refer to the articles posted between 11/05/09 and 12/14/09. Please note that Table 4 in the 12/4/09 Platinum Toolbox article includes an error that was corrected in the Analytical Toolbox article from 12/14/09. It also is included here.

Market Timing 

Market timing systems allow conditions to dictate the extent to which a method is invested. In this series two moving averages were assessed at the end of the month to determine whether or not the portfolio would be invested in SPY, the Standard & Poor's Depository ReceiptTM (SPDR®) which tracks the S&P® 500 Index (SPX). When SPY's 50-day simple moving average [SMA] was above its 200-day SMA, the portfolio would hold SPY the next month. This SMA combination was referred to as the longer or slower pair of SMAs. A second combination, the 20-day and 50-day SMAS was also tested as an alternative market timing approach.

Hedging

Two different hedge methods were tested for the stock holding in the portfolio. These include 1) SPY hedges based on the correlation of daily returns for the stock versus SPY and 2) and individual stock hedges using a Relative Strength [RS] method. The latter hedged just the weakest stock in the portfolio group of four.

In addition to testing results when these hedges were in place the entire holding period, a timing approach was also tested using the SMA filters on SPY. The former hedge techniques did not seem to accomplish the goals set out-reducing costs while maintaining effective hedges. Note that stock only portfolios were tested for twenty years while portfolios holding options were tested from six weeks to four years given constraints on historical data.

Results

Select results from the different tests appear here.

Table 1 provides a list of holdings for three different portfolios. The hedge for Portfolio 2 includes SPY puts as a hedge for the SPY and EBAY shares. The additional put protection for SPY used the high, positive correlation for EBAY relative to SPY. Portfolio 3 did not require a strong positive correlation between the stock and SPY, but did use SPY puts for overall portfolio protection.

 

Table 1: Portfolio Holdings for First Hedge Technique

Figure 1 through 3 provides six week portfolio charts from Optionetics Platinum for the three portfolios.

Figure 1: Portfolio 1 Equity Curve


 

Figure 2: Portfolio 2 Equity Curve


 

Figure 3: Portfolio 3 Equity Curve

Although the test period included a sideways to upward trending market, a bigger problem for the approach was the lack of stability for correlation values over the short-term. Table 2 provides a snapshot of correlation values using different return periods calculated on different days.

 

Table 2: Variable Correlations for Portfolio Holdings (vs SPY)

Results for other hedging approaches discussed were incorporated into the market timing results. Table 3 starts with market timing results for a portfolio consisting of SPY only over a twenty period.

 

Table 3: Return Results for Buy & Hold versus Market Timing for SPY

Table 4 provides test results for a four year period and uses starting balances from the twenty year tests. Holding period returns and annualized returns allow for an apples-to-apples comparison. In addition to testing market timing for a long position in SPY, the results for a timed hedge are included.

 

Table 4: Return Results for SPY Using Buy & Hold, Market Timing & Hedge Market Timing

The final set of results adds the stock position into the portfolio. The hedge is based on a relative strength test of the four holdings. The weakest stock of the four is hedged the next month. Please see the Analytical Toolbox article from earlier this week for more details. Again, the hedge was tested using a constant hedge approach and a timed approach using the SMAs.

 

Table 5: Return Results for Portfolio Using Hedges and Market Timing

It does appear that the slow timing technique improves portfolio returns whether it is used for timing the ETF purchase or a hedge. A downside to this approach is the additional costs due to commissions and slippage. A bigger issue for investors to consider is the tax implications.

Moving Forward

While mapping out your plan for 2010 and beyond, you may want to test the impact from the following rules or additional filters on the approaches discussed:

1. Varying the SMA periods
2. Using a group of related ETFs for the portfolio holdings
3. Applying timing to all portfolio holdings
4. Applying a more robust relative strength [RS] calculation
5. Consider gamma values in the hedge decision versus an initial delta neutral position

When testing different SMA periods, consider the term tested from both a trending and volatility standpoint. Be sure to compare results to buy and hold, as well as a portfolio with only risk-free returns (90 day t-bill). Also consider how taxes and slippage costs affect annual results. Keep in mind that dividends were not included in any of the tests.

Always, always perform a style check

Happy holidays and thanks to everyone who has made it another year for which I am grateful.

Clare White, CMT
Contributing Writer and Options Strategist
Optionetics.com ~ Your Options Education Site

Questions for Clare? Please visit the discussion board on the homepage of Optionetics.com.

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