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Big Breakthrough! Switcheroo!
Leveraged USA & Worldwide Systems Add 26,000%
to Unleveraged Return of 34% per Year
7.8 years June 28, 2002--April 14, 2010
Mostly USA ETFs & Worldwide ETFs Portfolios
Hypothetical--Weekly
Statistical Footnote below
ONCE UPON A TIME . . .
Since long, long ago, people ask which system I use, Mostly USA or Worldwide ETFs?
My answer is both. By use, they mean, and I mean: put my own personal, real money in. Sometimes, I would overweight one or the other. Other times, I would abandon one or the other, but never both. And I was never satisfied with that.
Sporadically, I would search for a method that would automatically choose the better-promising system every week. I never found one that worked well . . . until a few days ago.
I found a method, an algorithm, to use a fancy word in the jargon of the business, that worked well. It scored 4 to 5% better annual return than either of the portfolios alone. That's an historical, hypothetical back test.
It is reliable enough for me to decide to run a number of weeks of real-time performance results. If they behave well, the method will be incorporated into both portfolios to cite which is the better choice to hold going forward into the weeks ahead. That's the solid, good news--pointing toward upgrading into the two ETFs systems after further validation.
Meantime, no kidding, 26,000% is not a 'typo'. It is a genuine number. It is the difference between the ending values of the two red curves in the chart above. One uses leverage. The other does not. More on that in a minute.
The bottom curve on the chart is an indicator derived from continuous measures of relative strength of each portfolio. These are combined into a single ratio. This ratio depicts the stronger and weaker of the two and indicates which one to hold or to switch into.
You would cash out of one system and put the proceeds into the other. The new portfolio will show either its two top-ranked funds or short sales of its bottom-ranked fund(s). Thereafter, you hold or continue switching as the indicator calls for. There are about five switches per year. The vertical bars mark the date of the switch to the alternative better-choice portfolio.
The indicator numerical level has no meaning, but may suggest a weakening or strengthening bias of direction. Being above or below zero is what counts. When the oscillator is above zero, hold the Worldwide positions. When below zero, hold Mostly USA.
The test results produce 34.4% per year, compounded to a total again of 897% over the 7.8 years period shown vs. 2.1% per year compounded to a total gain of 18% for the S&P500. Cash did better than that at 2.2% per year from Treasury Bills.
Note the behavior profiles during the two bear-market periods (the magenta bars at the bottom of the chart). While the market tanked in each instance, -56% in the recent crash, the switch system methodology not only did not drop, it rose strongly and exploded upward in 2008.
Statistical Footnote
Compound average return 34.4% per year
Position still open as of 4/14/2010
Average holding period 10 weeks
Average profit per trade 10.0%
Average loss per trade -2.4%
Win/Lose ratio 6.3 to 1
Profit factor 28.1
Biggest win 75.8%
Largest loss -9.0%
Worst drawdown -20%
Average 5 switches per year
Longest single switch 52 weeks
(2/28/2003, Mostly USA)
If adopted, succeeding trades will be posted
on a real-time results page similar to this.
If you choose to hold cash during bear markets, your equity-curve profile would look something like this.
PART 2: LEVERAGE
This part may be considered shockingly speculative by some and should be with great caution and healthy skepticism.
In the galaxy of derivatives, wild species exist today that were unimaginable a few years ago and are even now not understood by anyone. Many people attribute to these derivatives the role of major cause of the panic and crash the world remains still in the throes of trying to resolve and regulate.
Nevertheless, a certain honorable respect is due to the ancestral patriarch of securities derivatives, tradeable stock options, as an orderly means of hedging and speculating. (You cannot have one without the other).
That's where the shoot-out-the-lights total percent gain in the top curve comes from. And that's a mere picayune of only 3x leverage. One of my old friends who is an avid trader and published commentator likes to see gains reported in dollars. $10,000 in the top curve eight years ago is $2,705,808
today and still getting better.
Is it possible? Well, sure. Can anything like that come close in the future? Well, I don't know. It's only 106% per year compounded. There is lots of private and proprietary money in big funds that are reported to get returns better than that.
At any rate, the following short table shows the results of different levels of leverage applied over the last eight years.
An unleveraged level (1 in the table below) produces a total gain of 887% over eight years. That's 34.4% compounded annually since 2002, produced by the switch system detailed on this page. The worst drawdown was -20%. But that can be ignored because the system's maximum realized loss was -9%, reported in the Statistical Footnote above.
As the leverage increases, drawdowns quickly reach intolerable levels until a multiple level of 8.31 puts you out of business. Little wonder there has been the world's greatest universal crash when the biggest, 'soundest', financial institutions on the planet ran multiplier levels up to 20, 30, and even 100 times leverage. These were managed by the smartest people in the world (even Nobel Prize winners among them) accountable for products they didn't understand then and don't even do to this day.
But happily, we can dispense with the last column entirely. It simply doesn't apply when we use options instead of borrowing margin to raise leverage levels of return on our portfolios. More on options below in Part 3.
THE EFFECT OF LEVERAGE ON SWITCH TRADES
Mostly USA & Worldwide ETFs Portfolios
Hypothetical
Eight Years 2002-2010
Statistics & Notes below
|
tot% |
|
|
|
levg |
gain |
%/yr |
dd |
|
1 |
887 |
34.4 |
-20.0 |
|
2 |
6291 |
71.1 |
-38.2 |
|
3 |
26958 |
106.1 |
-54.1 |
|
4 |
73494 |
134.6 |
-67.5 |
|
5 |
123350 |
150.8 |
-78.4 |
|
6 |
117273 |
149.1 |
-86.7 |
|
7 |
51645 |
124.1 |
-92.8 |
|
8 |
4301 |
63.0 |
-96.9 |
|
9 |
-648 |
-ruin- |
-99.4 |
|
|
|
|
|
SP500 |
18 |
2.1 |
-56.2 |
PART 3: OPTIONS
Options are marvelous to control risk. In lieu of the wild drawdowns above, we can set a single, fixed level of risk for each position we want to own. Further, we can increase the initial leverage to 6x or more while the multiple can then increase to much higher levels as the ETF rises, and the option becomes more profitable.
The well known risk in buying options is that they can become worthless on expiration date.
But by buying options with sufficient time left to expiration date, you will never get to zero value. A switch signal occurs first, or, when little time remains, you will roll out to a later expiration date further in the future.
Along these lines, It may be worthwhile to test what option characteristics will result in profits, if any. Here are some prices for a pair of ETFs held in the Worldwide portfolio and a single option from Mostly USA to see where they go in the future.
DISTANT OPTIONS FOR SWITCH POSITIONS
As of Monday, April 12, 2010 9:30 a.m. EDT
|
Stock |
Strike |
|
|
|
% of |
|
mos to |
|
price |
price |
Expiration |
Bid |
Ask |
Stock |
levg |
expire |
|
IWM |
70.40 |
70 |
12/30/10 |
5.40 |
5.45 |
7.7 |
6.5 |
8.6 |
|
EWW |
54.81 |
55 |
1/21/11 |
4.10 |
4.40 |
8.0 |
6.2 |
9.3 |
|
IJR |
61.61 |
61 |
11/19/10 |
4.50 |
4.80 |
7.8 |
6.4 |
7.3 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
avg |
7.9 |
6.4 |
8.4 |
For example buying the IWM option to open at the ask price of 5.45 gives a leverage multiple of 6.5x over buying the IWM ETF outright. The multiple will shift as the option matures, upward if IWM increases in price and vice versa and decreases if the price drops. It is flexible and works in your favor. But buying far-out expiration dates has unique, potentially adverse risks in dynamic volatility shifts and possible illiquidity characteristics that would have to be priced in by the market maker.
Caveat. The latter part of this article is highly theoretical. Hence, I would urge more than the usual amount of care in paying attention to what it is suggesting as a possible plan of action. If you have questions about options and their use, please consult a knowledgeable, experienced professional. Or show him or her the options section of this page for a more detailed explanation for your benefit.
Parts 1 and 2 have demonstrated good test results, subject to further real-time verification and the potential impact of leverage on results and risk. If validated after further real-time testing, I will adopt the switch method into the two ETFs systems and report it each week in the two systems letters.
Written
4/9 to 4/18/2010
Posted
4/18/2010 2:33 p.m. ET
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