Bracing For The Next Correction: Where Most Investors Fail
Summary
Over the past years I've tried to time the market thinking I would stay ahead of the herd. Quickly entering positions and scooping up small profits. I wasn't investing strategically, although I was paying enough attention to many investment rules: diversifying across different industries, identifying stocks with plenty of upside potential... However, I didn't incorporate the following six concepts into our entire portfolio strategy:
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Strategy selection (for example covered-call writing) to improve your success rate
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Drawdown graphs
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Sharpe Ratio
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Impact of luck on your final outcome
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Correlation
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Alpha during corrections
Let's break these factors down and point out why they are so indispensable to your long-term investment success. Before we do that, an overall technical picture of the stock market is warranted.
Technical Analysis: Déja-Vu of 2015, 2016 and 2018
As can be seen from the graph below, the MSCI World ACWI has recently dropped below the overbought RSI line indicating a continuation of the pullback to $59.5 - $60 is likely. If we were to exclude the positive return contribution of big Tech the whole story boils down to the following: sideways price action with heightened volatility.
(Source: Pro Real Time)
Looking at the Russell 2000, the US index representing the 'old economy', seems to be weakening as well. We currently have on a hedge on IWM and the detailed explanations on how to play it can be found in this article. We are quite neutral on IWM and with a relatively simple option strategy our main goal is to reduce volatility in our daily and weekly P&L. Or to put another way: to smooth the daily moves in portfolio out instead of betting on a short-term correction/pullback. (IWM)
(Source: Pro Real Time)
Emerging Markets are struggling to break out as well. There's little that can force them to turn the tide.
(Source: Pro Real Time)
Conversely, long-term bonds seem to be setting up for a powerful breakout once we push through the $172.50 resistance. While we don't trade bonds, TLT's technical picture validates our case for increasing volatility and sideways price action on the stock market. (TLT)
(Source: Pro Real Time)
Similar to bonds, gold believers should be pleased with the graph below. More importantly, commodity prices are positively correlated with their implied volatility, making call LEAPs on gold very attractive to capture both IV expansion and positive delta. (GLD)
(Source: Pro Real Time)
And last but not least: the VIX is still in backwardation which is an unusual phenomenon...(VIX)
(Source: Barchart)
Strategy Selection: A Simple Covered Call Can Increase Your Probability of Success
One of the most intuitive option strategies is the covered-call write. You can find the cumulative performance of this strategy for Dollar General (DG) in the graph below.
It consists of 3 curves representing buy and hold investing (excluding dividends) and an at-the-money covered call (or as close as possible) but with a different management tactic. The red line does not roll down the strike when a correction occurs, whereas the orange line continuously adjusts this 'limit' price. As you already know, this is the price that we're willing to sell our shares for.
Since we want to track the overall performance of selling at-the-money covered calls on Dollar General, we will sometimes be forced to roll out for a debit. There's no upside beyond the strike price. If the price of the stock goes up, we roll out regardless of whether or not we're paying a net debit. That's because - under real-life circumstances - we still want to hold onto our long-term winners and generate time value by selecting strike prices close to their share price.
(Source: Option Generator Research)
Sharpe, What?
Most investors will look solely at the absolute return instead of the Sharpe Ratio (return per unit of risk). Over the past decade, the covered-call strategy on DG (red line) would have produced a total return in excess of 22% with 15% standard deviation. The buy-and-hold performance would have been 19% yet with 26% standard deviation. As can be noticed from the chart above, the orange line has tracked the buy-and-hold investor but with 52% less annual volatility! Nonetheless, not every stock fits the bill as covered-call candidate: here's where our extensive and unique backtesting programming comes into play.
It's important to realize that the combination of different option strategies (strategy diversification) leads to sustainable long-term success.
In terms of the probability of profit, 73% of the months were profitable for passive covered-call writing. Would you like to win 73% or 60% (buy-and-hold) of the time? Needless to say that with a little more effort you can enhance consistency in your results.
(Source: Option Generator Research)
Mind the Drawdowns!
Do you sleep well at night? Let's take a look at the drawdown graphs. Smaller drawdowns, faster recoveries... AND most of the time, selling covered calls on DG has so far yielded better returns than the S&P-500 during past corrections.
(Source: Option Generator Research)
While passive ETF investing is the easiest way of allocating your capital to the stock market, I'd like to make the case for strategic investing. Not relying upon equity returns to be a successful investor. Below you can find the returns of the passive covered-call strategy (not rolling down the strikes during corrections) and an investment in the SPY tracker. Place your bets, please. (SPY)
(Source: Option Generator Research)
Don't Rely on Luck
Let's say that you started in June 2010 and made 12 monthly purchases of DG stock for buy-and-hold and entered 12 different covered-call trades for 9 consecutive years. What would the final return have looked like if you picked the bottom returns, the 25% worst returns, median returns and 25% best returns? The chart below tells the whole story: a higher probability of profit and smaller negative impact of bad timing on our returns.
(Source: Option Generator Research)
(Source: Option Generator Research)
Compound interest can turn out to be a disappointing mechanism if volatility or bad timing starts to kick in. Again, improving consistency in our returns will make it easier to continuously execute our strategy. As such, a probability-focused approach will bear fruit in the long run.
(Source: Option Generator Research)
Correlation: In Search of Real Asset Diversification
Correlation is a metric most retail investor don't pay attention to. Why should it bother you? The way two assets are linked to each other is of key importance to understand where your real risk lies. If you invest in ETFs, there's a good chance that their correlation approaches +1. So does it make sense to diversify across many ETFs when they are virtually the same underlying most of the time? In case of Dollar General, correlation with the SPY has stood at +0.3 over the past 5.5 years. Over a 3-month time span there's a good chance that DG isn't correlated with the S&P-500 if and when a correction takes place.
(Source: Option Generator Research)
Seeking Alpha
The last important metric I'd like to present to you in this article: alpha. How does a stock hold up against the benchmark during uncertain times? Can it widen the outperformance gap to an even larger extent? Since 2018 Dollar General has managed to handsomely beat the S&P-500, especially in times of a correction and increasing volatility.
Understanding all of the 6 factors outlined in this article will help you stay on track to become a better investor.
(Source: Option Generator Research)