Playing both sides

By Lewis A. Glenn, Ph.D.
Anyone who still believes a buy-and-hold strategy is a good way to invest must have been living on another planet over the past 10 years.

The S&P 500 index (SPX) slid 16.3 percent from May 2000 to May 2010, which included a 38-percent drop in 2008, a 23-percent rebound in 2009, and a basically flat trajectory so far in 2010. Unlike buy-and-hold, the key to successful investing is knowing when to fold.

“Market timing with volatility” (Active Trader, July 2009) outlined a long-only strategy designed to capture most of the gain in bull markets while avoiding most of the pain in bear markets. This long-only approach entered the market only when volatility, as measured by a 200-day simple moving average (SMA) of the VIX, was low:

1. Go long if the VIX’s 200-day SMA < 20.

If the 200-day VIX SMA was above 20, the strategy entered only when an x-day SMA had climbed enough over the past y days to justify moving out of cash. Testing in stock-index ETFs — S&P 500 (SPY), Nasdaq 100 (QQQQ), and the Dow Jones Industrial Average (DIA) — found viable results using a 200-day SMA of price compared over a 21-day period. Specifically, the ratio of yesterday’s 200-day SMA value to its value 21 days ago had to be larger than the interest amount you could earn at 3 percent over the past 20 days, compounded daily:

2. Go long if the ratio of yesterday’s 200-day SMA value to its value 21 days ago is above 1.00162096 (1 + 3% annual rate compounded daily for 20 days).

3. Sell if the ratio of yesterday’s 200-day MA value to its value 21 days ago is below 1.00162096.

The following revised strategy modifies the original trade rules, adds a short-selling component, and tests performance on three additional stock-index ETFs.

Fine-tuning the long signals
Strategies based on moving averages can generate “whipsaw trades” when price repeatedly reverses direction in a congestion phase. All market-timing methods face this problem to some degree. In the case of this strategy, stricter entry rules significantly reduced the number of losing trades without degrading performance much. Specifically, the annualized percent return the 200-day SMA (rule 2) had to exceed over the look-back period was increased from 3 to 6 percent.

The interest rate earned when the strategy moved into cash was also changed. Originally, it earned interest at a fixed three-percent annual rate, compounded daily. This was fairly conservative in the 90s and in the early 2000s. But interest rates have dropped precipitously and are now near zero. A more accurate measure of the true return you might expect in cash is the CBOE short-term interest rate index (IRX), which tracks the discount rate of the most recently auctioned 13-week U.S. Treasury Bill. The new rules are:

1. Go long if the CBOE volatility index’s (VIX) 200-day SMA < 20.

2. If the VIX’s 200-day SMA ≥ 20, hold (or enter) long position only if the ratio of yesterday’s underlying 200-day SMA value to its value 21 days ago is above 1.003197 (1 + 6 percent annual rate compounded daily for 20 days).

3. Sell if the VIX’s 200-day SMA ≥ 20 and that ratio drops below 1.003197.

For the complete article, see the September 2010 issue of Active Trader magazine. Click here to subscribe.



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