How Does The Market Know?
Seriously – its spooky!
Take a look at the chart below – notice that the SPY has closed almost exactly on the correction line then bounced off again. When you think of the millions of trades with hundreds of stocks that make the SPY index every day its hard to believe that this stuff actually works – but it does!
So where does this leave the ITM strategy? Recently it has looked as though we were closing in on our golden cross, but that’s been put on hold for now. We are still on the sidelines.
Is this just a temporary setback? Or something more serious? Let’s have a look.
Stock Market Quotes
I always monitor the mood of the market, mainly by looking at headlines. Some from the past week:
- Bear Market Remains Incomplete, Morgan Stanley Analyst Warns
- Bear market poised to last longer despite recent Wall Street rally
- Use the rally to sell stocks you want to get rid of
- Bear market rally won’t last much longer
- It’s doomed, it’s a bear-market rally, a rebound that won’t last
- Bank of America’s July fund manager survey: global growth optimism at record lows
- US consumer sentiment sits near record lows in one survey dating to 1952. European polls are similarly glum.
- Bleak headlines warn of an energy-driven global recession, spurred by Russia throttling gas supplies to Europe
- Yes, global recession fears are widespread but markets somehow haven’t pre-priced them.
- The Stock Market Rally Looks a Bit Squirrely (what does that even mean???)
They seem to be unremittingly negative so I would guess that we are in pessimism.
It reminds me of 2 quotes, one of which I think is great, the other not so much.
Bull markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria.
So where are we now? Definitely not in euphoria, or even optimism. There could be a case for skepticism, but right now I think that the press is relentlessly pessimistic.
Another quote you often hear is:
“Be fearful when others are greedy, and greedy when others are fearful.
At first glance, it says the same thing, but when you look at it it is a call to action rather than an observation. Sure, buy when others are fearful – but they are fearful for rather a long time. For perspective, let’s look at the GFC: where would you have bought?
People look pretty fearful, don’t they? I’ll follow Warren’s advice. I’ll buy at 132.
Oops, didn’t work, now its even lower. But, people look even more fearful now. I’ll buy at 123.
Oh dear, that didn’t work. People have got even more fearful! This has got to be maximum fear, just as Warren was saying. I’ll buy at 100. That HAS to be a bargain.
Two days and its gone down another 13%. Aaaargh!! Mr Buffett??? This has GOT to be maximum fear now. I’ll buy at 88.
Its gone down even more! I’ll buy at 82 – that has GOT to be a bargain!
Looks like it is drifting down, but nobody looks very scared – look at all these little candles! No monster red ones. Can’t be real fear. Not buying here!
Oops – you missed out buying at 68 – the bottom of the market.
So you can see that following Buffett’s rules we could have bought in at 132, 123, 100, 88 and 82 when it still had further to drop. Unfortunately, that is the problem with his advice. There is no absolute measure of fearfulness which is why I find this advice very trite. Its basically saying ‘buy at the bottom of the market’- well, if we knew when that was then we would all be extremely rich! And just for perspective here’s another headline with a dire warning:
Europe is melting in a heat wave!
Goodness, that must be serious! Well. I’ve been here in Europe the whole time and no-one seems particularly perturbed. They call it ‘summer’!
Q & A
Readers questions answered. If you have a question then fill out the contact form and I will answer it (if I can) in the next blog.
How do you know the options prices for backtesting?
Option pricing is complicated; the Black-Scholes method is generally accepted, and requires you to know FOR EVERY SINGLE DAY of the backtest the:
- Volatility
- Price of the underlying asset
- Strike price of the option, the
- Time until expiration of the option, and the
- Risk-free interest rate
Obviously 2, 3 and 4 are easy as we know what option(s) we are holding, but the daily volatility and interest rate the is not something easily obtainable. Luckily, we don’t have to know these (1 & 5) when we are backtesting ITM as they only affect time value, not intrinsic value.
One of our entry signals is that the intrinsic value is over 99% and the time value is less than 1%. So, for the purposes of backtesting the assumption was made that the time value was exactly 1%. Of course, most of the time it wasn’t; we bought in cheaper than that, so we were overestimating what we paid for the option and underestimating the results. As you know the time value drops off a cliff within 30 days of expiry, so the assumptions were made that if we sold more than 30 days out our sale price would include 1% time value and be the same as the buy price. If we sold within 30 days then the time value was completely lost, i.e. it was assumed to be zero.
You can see that this has the effect of making the ITM and ITMB results smaller than they would otherwise be, but that’s a good thing when backtesting; you know it is underestimating the actual results.
Why don’t you just use a 2X or 3X ETF?
I am often asked – and it has been in reviews – why I don’t just use a leveraged ETF? A rookie mistake. Using 2 or 3 times ETFs do NOT give the same results as either ITM or ITMB. This is discussed in the books, and in previous blog post Here’s the link: Leveraged ETFs.
Are you going to do a book about a sideways market?
Hmmm . . . I am being asked this a lot. It seems to be an indication that people are expecting the market to go sideways, which in itself is interesting.
I have in the past had a system that traded the sideways market, using weekly options. Some years ago, I actually wrote some software (for myself only) where you entered the option date, strike, expiry, current price, volatility and it estimated, based on backtesting 25 years of data, the percentage probability that the price in the next week would increase by more than 2%, 3% and 4%. You could then write OTM options against it (covered calls to be safe).
While the weekly gains were laughably small (1 – 2%) if you did that every week then the annual returns were significant.
It worked well, and flushed with success I excitedly explained the concept and practicalities to a ‘friend’ in the industry. He then, I discovered, started flogging it as an ‘Íncome Strategy’ to his (paying) members. To say I was upset was a bit of an understatement and, in a fit of pique, I let the whole thing lapse and moved on to pastures new. Doing it every week was a bit of a nuisance anyway.
Should I resurrect it again? Probably. Will I? Not sure about that. Let me know what you think via the contact form.
Do you really think you are the first person to discover in the money options??
No. Obviously not. That was never claimed in any of the books. I was simply showing a way to trade them.
Email Notifications of Blog Updates
Last update I didn’t send out an email, partly as an experiment, and partly because Mailchimp was jacking up at the hotel connection. According to Google Analytics, the blog post had only about a third of the readers it normally gets, so I am re-instating it. You can always opt out at the bottom of the email.
Last Night in France
Who knew that 100 days could go so quickly? Yet it has. Here I am, where I started in May, at the Hilton in CDG, flying out early tomorrow. Sad? Yes. But it is time to go; the trees are turning to autumn, the leaves are starting to fall, the roses are finished, and the sunsets are getting earlier.
So back to an Australian spring and summer where everything is just awakening – but, of course, I’ll be back to France next May for another summer. No more dreary winters. Love it!!
And did you know that France had its very own pyramid?
It dates from Roman times, and the hole in the middle is from excavations in 1640 when they were trying to find out if anyone was buried inside. There wasn’t!
