Wednesday, August 15, 2012

DN optiions & more....8.15.12

First, some further clarifications on the use of options with the delta models:
Backtesting option performance metrics is a notoriously difficult task.  Data providers do not routinely offer historical option data and that data itself is subject to wide variation depending on the time of day when the quotes were taken, the size of the spread and whether the option was bought or sold.  It's gets worst from there.
The summary option results presented in the delta models were based on current volatility and spread values, which obviously have not been consistent over the past 5 years so the results should not be used to gauge actual returns that may have been accrued during that time frame.  The intent was to show an approach rather than project actual returns that could be expected.  I ran this same model back in December when VIX was around 31 and the results were considerably better ... about twice as volatility has a huge role in the results...and the risk...involved.
That being said, a delta positive model which sells slightly OTM calls should theoretically provide an attractive risk/reward scenario...and while it may be instructive to post regular updates for a model portfolio employing this strategy it is currently beyond the scope of this newsletter. 
Concerning the delta neutral model, the trick to making such a model pay out is in only trading one side of the model at a time.  How do you know which side to play?  This is where the momentum ranking matrix comes in helpful, especially if used in conjunction with the delta bands setup which looks for situations of extreme short term % change in momentum and then bets on a reverse move.

This leads to the next development in the newsletter based on survey results:

The underlying focus of Mosaic remains long term, low drawdown and low maintenance investment models that the average trader/investor can implement and track.  Nevertheless, many investors also want a more dynamic model in hopes of gaming the markets a bit and supplementing the turtle like revenue stream provided by Mosaic.

To these ends I will be merging the Situations with a more robust rotational model...Mosaic 10... that will trade once a week.  The model is composed of 10 ETFs and the model holds the top 5 components of that model. Rebalancing occurs at Monday's open + 60 minutes with a couple caveats.  I'll post the preliminary model over the weekend.  Within the framework of this model there are opportunities for most situations:
1. Long term investment..requires rebalancing once a week although positions may prevail for some time.      
2. Short term ETF single ETFs or a basket of ETFs with the highest momentum metrics
3. Short term option trading...using options on the highest ranked ETFs for 3-7 day trades.  The option side of the strategy is obviously the most complex and the most volatile and is not designed for unsophisticated option traders.  It must be expected that a morning gain can turn into an afternoon loss and option characteristics like spread, open interest and daily volume have to be factored into any investment decision.  While certain ETFs, like XLK, have demonstrated their utility in a long term model like TAQK, few thinking traders would go near the options because they demonstrate horrible volume and open interest.  As such, only those ETFs with robust option characteristics should be considered for use within the Mosaic 10 ranking, a point that will be emphasized in subsequent posts.
That's it for now. 
Thanks for the survey feedback. It is appreciated and helps me focus my efforts to meet your goals.