The AIQ code based on Perry Kaufman’s article in March 2014 Stocks & Commodities, “Timing The Market With Pairs Logic,” is provided at www.TradersEdgeSystems.com/traderstips.htm.

The code I am providing will backtest only the long trading and will not test the hedging portion of the system. For live trading, I provided a manual input for the total value of the open positions, which would have to be computed separately and then entered daily as an input before the daily report is run once the hedge rule becomes true.

!TIMING THE MARKET WITH PAIRS
!Author: Perry Kaufman, TASC March 2014
!Coded by: Richard Denning 1/7/2014
!www.TradersEdgeSystems.com
!INPUTS:
stoLen is 60.
idx is "NDX".
hedgeETF is "PSQ".
eLvl is 10.
xLvl is 50.
sLoss is 0.10.
hedgeLen is 60.
hedgeRatio is 0.50.
minP is 3.
invest is 5000.          
totValOpenPos is 100000. !open position value must be set manually
H is [high].
L is [low].
C is [close].
O is [open].
idxH is tickerUDF(idx,H).
idxL is tickerUDF(idx,L).
idxC is tickerUDF(idx,C).
idxO is tickerUDF(idx,O).
hedgeC is tickerUDF(hedgeETF,C).
PEP is {position entry price}.
!STRESS CODE:
rngStk is highresult(H,stoLen) - lowresult(L,stoLen).
rngIdx is highresult(idxH,stoLen) - lowresult(idxL,stoLen).
stoStk is (C - lowresult(L,stoLen)) / rngStk.
stoIdx is (idxC - lowresult(idxL,stoLen)) / rngIdx.
stoDiff is stoStk - StoIdx.
rngDiff is highresult(stoDiff,stoLen) - lowresult(stoDiff,stoLen).
stressVal is ((stoDiff - lowresult(stoDiff,stoLen)) / rngDiff) * 100.
!PAIRS SYSTEM CODE:
Buy if C > minP and countof(C > minP,4,1)=4 and stressVal <= eLvl and symbol()<>hedgeETF.
StressExit if stressVal >= xLvl.
ExitBuy if countof(C > minP,5)<>5 or C/PEP-1 < -sLoss or StressExit.
!TREND CODE:
idxTrnd is simpleavg(idxC,hedgeLen).
Hedge if idxTrnd < valresult(idxTrnd,1) and symbol()=hedgeETF . 
!SIZING CODE:
chgStk is C/valresult(C,1) - 1.
chgIdx is idxC/valresult(idxC,1) - 1.
idxSMA is simpleavg(idxC,hedgeLen).
size is floor(invest / C).
hedgeSize is floor(totValOpenPos / hedgeC*hedgeRatio) .
ShowAllValues if countof(C > minP,5)=5.

To get a correlated list of stocks that show good correlation to the index of choice (I used the NDX), AIQ has a matchmaker module that will quickly generate a list of stocks that show significant correlation to an index. In Figure 7, I show the matchmaker setup I used to quickly get a list of stocks in the NASDAQ 100 that were highly correlated to the NDX. In Figure 8, I show the results (part of which are hidden). After highlighting the ones desired for a list, simply click on the “data manager” button and a list is created, which is then used to run the tests.

 

FIGURE 7: AIQ, MATCHMAKER SETUP. Here is the setup used to get a list of stocks in the NASDAQ 100 that are highly correlated to the NDX.

 

 

FIGURE 8: AIQ, RESULTING LIST. Here are sample results of running the setup shown in Figure 7.

As I write the stock market is headed higher.  As a trend-follower by nature (sorry it’s just my nature) I try to avoid sitting around and stewing in “The End is Near” type of thinking. For the record there is a lesson in that.  Stop for a moment and think about all of the predictions of “the top” you have heard or read in roughly the last 17 months or so as the market has moved relentlessly higher (Thank you Fed – for now).

Those predictions all fall into one of three categories – Wrong, wrong or wrong.

Still, the phrase that “all good things got to come to an end” remains essentially a universal truth.  My hope is that the major averages (and the majority of stocks) will break through to the upside and take out their recent highs and continue to power higher.  But if this rally fails…………it might make sense to be prepared.  Please note that I am not intending to imply that if the market fails to make new highs that Armageddon will ensue.  But the market does appear to be losing some momentum (more on this topic in a moment).  And once the “worm turns”, well, corrections tend to happen pretty quickly and at times pretty ferociously. 

So my best advice at the moment is “enjoy the ride, but please take a moment to locate the nearest exit.”   

Is The Market Losing Momentum?
Figure 1 displays the S&P 500 daily bar chart at the top with the 3-day RSI and the MACD (18/37/9) indicator at the bottom.

Note that during the second half of 2013 as the S&P 500 moved higher both of the indicators confirmed the move.  Since the first of this year both indicators have been forming a bearish divergence – i.e., price moves to a new high while the indicators do not.  Now once again it should be noted that simple divergences happen from time to time and do not imply the end of the world as we know it.  But they do flash a warning sign that alert traders should pay attention.

So there are two scenarios to watch for:

1) The S&P 500 index and other major average move to new highs and the indicators “stop diverging” and once again “start confirming” (This is “Good”).

2) The S&P 500 and other major average fail to make a new high or briefly reach new high ground and then reverse, while the indicators continue to signal weakness (This is “Bad”).
My advice is to pay close attention in the days and week ahead. 

One Way to Play

This idea is merely “food for thought” and a little too soon to act upon in my opinion (i.e., the time to consider acting is if and when the market fails to follow through to a new high and the indicators remain weak).  But if you want to consider a “cheap hedge” here is an example that uses the “Garbage Trade” I’ve written about (that I learned from Gustavo Guzman) of late.
The example trade displayed in Figure 2 involves:

Buying 1 June SPY 178 put option
Selling 2 June SPY 169 put options
Buying 1 June SPY 160 put options

At present prices this trade costs $67 to enter.  If SPY got back down to about 181 this trade would generate an open profit in the range of 100%.  If things actually did “fall apart” (again, not “predicting” just “preparing”) this trade would generate a profit of several hundred percent.
Again, not really a trade to make right now, but rather an idea to keep in the back of your mind, you know, just in case…..

Jay Kaeppel  Chief Market Analyst at JayOnTheMarkets.com and AIQ TradingExpert Pro (http://www.aiq.com) client

So you see what I was talking about, right?  Under the category of “I hate it when I’m right”, last week I wrote “when I write an article about a trend that has been playing out time and time again over a several year period – that can pretty much be counted on to put an end to that trend”, referring to the fact that ticker VXX has been in a prolonged downtrend for a number of years.

Within minutes (or so it seems) the Russian Army is on the move. Coincidence? OK, probably so, but geez, maybe I should try picking tops and bottoms…

Anyway, in light of the newfound fear and loathing that popped back up over the weekend, it is time to review a useful strategy for traders concerned about the downside in the near term.

The Garbage Trade

Several years ago I learned a simple hedging strategy from Gustavo Guzman, a former colleague of mine.  He dubbed it the “Garbage Trade”.  But don’t be fooled by the name, for it is anything but. 
Essentially a hedging strategy, the basic idea of this simple option strategy is to risk a little bit of capital on something that most people don’t think is going to happen.  If it doesn’t happen, OK, you lose a little.  But if it does happen, you make a whole lot.

One word of warning: for the “average” investor – one whose basic approach to investing is one of “buy a stock or mutual fund or ETF and hope it goes up” – this type of trading is quite a foreign concept.  Of course, given the world we live in today, considering alternative ideas to investing and trading might be a good thing.

The Starting Point

The basic idea Guzman taught was that after a market (especially the stock market) had experienced a good run up, a pullback of some sort was invariably due.  So his suggestion was after a run up, buy a put option roughly 5% out of the money.  Then go down the strike prices until you find a put option that you can sell two of which will pay for the first put option you bought (example to follow).  Then if you had gone down say three strike prices from the option you bought to the option you sold, then go down three more strike prices and buy one put at that price. 

Right now all of the “non option junkies” have their fingers poised over the arrow to go back to the Main Web Page.  But wait!! Please at least consider the example below.

In Figure 1 we see a bar chart for ticker IWM, an ETF that tracks the Russell 2000.  Now let’s assume that a trader is concerned about the potential for a pullback – let’s say based on current geopolitical goings on – but not necessarily outright bearish.  In other words, he doesn’t want to “Sell Everything!”, but would like some protection if things go south for a while. 

In Figure 1 we can see that if IWM starts to decline there are several natural “price targets” where a trader might consider taking a profit.  But I am getting ahead of myself.

Using Guzman’s outline for the Garbage Trade, one possibility is as follows:

-IWM shares are trading on 3/4/2014 at 120.32.
-If we multiply this by 0.95 we get 114.30
-We can choose either the 114 or the 115 strike price put.  Due to higher volume I will select the May 115 put.
-In order to take in enough premium to pay for the 1115 put we would sell 2 May 109 puts for 1.13 each (or $113 x 2 = $226 premium taken in)
-We then go own six more point and buy one May 103 put for 0.60, or $61.
All told, it costs all of $55 to buy a 1 by 2 by 1 position.  The risk curves for a 10-lot position costing $550 appears in Figures 2 and 3.

Figure 2 – IWM Garbage Trade (Courtesy: www.OptionsAnalysis.com)Figure 3 – IWM Garbage Trade (Courtesy: www.OptionsAnalysis.com)

So basically, one of a couple things will happen.  In a nutshell, either IWM will suffer a pullback and this position will offer the potential to make a fairly high return on capital, or the trader stands to lose a maximum of $560.

A couple of things to note:

*If IWM moves to new highs the trader can either:
a. Exit the trade and cut his loss
b. Continue to hold the position – at least for a while – just in case something bad happens later rather than sooner

*If IWM does start to decline then the trader should have a profit target in mind and should pay attention to the price level at which the risk curve for the latest date will “peak” and start to “roll back down.”  Figure 1 displays several potentially useful “price target levels” where a trader might consider taking a full or partial profit.

Summary

As always, this example is not presented as a “recommendation”.  It is simply an example of one way to get a little exposure to the downside if you start to feel some “concern.”

The vast majority of traders who look to options focus on buying calls and puts in hopes of maximizing a specific market timing method, and/or selling covered calls against stocks they hold.  Nothing wrong with these ideas, but the real power of options is that they afford you the opportunity to “attempt” things you normally could not or would not do using stocks, ETFs or futures.

The Garbage Trade is an example of one way to use options to risk small amounts of capital with the potential for significant percentage gains.

As always this example is not a “recommendation”, only an example.  Note that it would seem like an illogical time to put on a trade like this.  The stock market has bounced back from the Russia/Ukraine crisis in one day and the current trend clearly remains to the upside.

For the record: At exactly the point when the Garbage Trade seems like a waste of money….is exactly the time to consider putting it on.

Jay Kaeppel  Chief Market Analyst at JayOnTheMarkets.com and AIQ TradingExpert Pro (http://www.aiq.com) client

Sometimes you can just tell when something is going to turn around? Like for instance, when I write an article about a trend that has been playing out time and time again over a several year period – that can pretty much be counted on to put an end to that trend (sorry for the paranoia, but as far as the markets go, it’s a “learned response”).

So with that word of warning in place, here goes.

The ETF ticker VXX is intended to track the widely followed VIX Index. And it does in a sense, expect that really it doesn’t. To better understand that seeming bit of gibberish simply glance at Figure 1. In the top clip you see the actual VIX Index. In the bottom clip you see the price action for ticker VXX.

Basically the “theory” is that over the long run the downward bias in VXX will persist (with inevitable periods of strength. So the idea is simply that every time VXX “pops it’s head up”, we whack it and play the downside. The best way to do this – in my opinion – is with put options on VXX. The alternative is to sell short shares of VXX, but that involves unlimited risk, and potentially a lot of it – if something unexpectedly bad happens that affects the stock market, VXX is capable of shooting a great deal higher in a short period of time. Buying a put option on VXX at least insures limited risk.

 

The other “key” is deciding when to get out. I am not going to address specifics in this article but there are many possibilities:

*First profitable close

*x-day RSI drops below y

*Some other indicator reaches oversold levels

*Etc.

As far as which specific put option to buy, I am going to go with the “there is not necessarily one best option to trade” answer. Different traders have different levels of aggressiveness and risk tolerance when it comes to choosing trades. In general the shorter-term the option the greater the potential if you are exactly correct in your timing, but the more quickly you can lose money if the VXX goes sideways to higher for a while. So as a rule of thumb I would say it is better to consider options with a minimum of 30 days left until expiration. Beyond that, the basic choices are:

1) The lowest “Percent to Double”: This calculation measures how far the underlying must move in order for the option to double in price. This typically involves buying out-of-the-money options and is considered more of a “high risk, high reward” choice compared to the other choices that follow.

 2) The highest “Gamma”: For people who don’t know the option “Greeks”, it can be boiled down pretty simply. “Delta” tells you how much the option should move if the underlying moves $1 in price. So a “Delta” of 50 means that if the underlying security moves $1 in price the option will move (roughly) fifty cents. 

“Gamma” tell you how much the “Delta” will change if the underlying moves $1 in price. In more general terms “Gamma” can guide you to options with the most immediate “bang for the buck.”

3) Deep-in-the-money puts: This choice offers the least leverage but also limits the negative effect of time decay (because there simply isn’t much time premium built into the option price) and can start making money point-for-point with the underlying fairly quickly.

 

 

Now that I have planted the idea that playing the short side of VXX is a good idea I would not be surprised to see some unforeseen event cause volatility to trend sharply higher in the not too distant future. But remember, the purpose of this article is not to compel you to “take the next trade”, but to identify and consider opportunities that may occur on a fairly consistent basis into the future.

Jay Kaeppel  Chief Market Analyst at JayOnTheMarkets.com and AIQ TradingExpert Pro (http://www.aiq.com) client

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