The Option Strategist Newsletter 2014 Market Review

By Lawrence G. McMillan

Frankly, I don’t put much credence in long-term projections, and neither should you.  How many people have you seen on TV making predictions without the least amount of statistical backing?  Those would better be called “guesses” or “wishful thinking.”  The worst (or best, if you’re cynical) was the CNBC reporter who made sports predictions for next year.  One of those was that the 36-year drought in horse racing’s Triple Crown would come to an end (the last Triple Crown winner was Affirmed, in 1978).  Okay, why?  But there was no “why.”  There was no analysis of this year’s crop of 2-year old horses (3-year olds race for the Triple Crown), nor any analysis of anything else that might contribute to a Triple Crown winner in 2015 – just the prediction.  That’s not a prediction, it’s just a guess based on nothing.

Even if one does have some historic data to lean on, a prediction for the course of an entire year could easily go awry, for a year is a long time.  But there are some things that seem to give us an increased probability.

2014 Recap

I may be jumping around a bit in introducing this here, but I pulled out our forecast for 2014 (Volume 22, No. 24).  The conclusion was that “it seem likely that 2014 will be an up year, but it will likely be a modest gain – perhaps 10% or less.”  Currently it’s about a 12% gain for 2014.

We also projected more substantial corrections and therefore increased volatility.  That didn’t occur uniformly, but the corrections that did occur were fast and somewhat nasty – especially those in January, October, and December.  

So that wasn’t a bad forecast, but it was hardly “out on a ledge,” nor was it something that we even thought about once it was made.

System Performance in 2014

More important, and of far more relevance, is how our major systems did in 2014.  In general, it was a good year for system trading – as it was for many other styles.  I’m not saying this is the only way to trade, but it certainly is one way that keeps traders more or less in tune with market trends – even relatively short-term ones.

$VIX Spike Peak Buy Signals

A $VIX spike peak buy signal occurs when the CBOE’s volatility index ($VIX) rises swiftly and then snaps back down, leaving a spike peak on the chart.  We have specific rules as to what constitutes a buy signal, but they are too long to list here.

Please refer to the chart of $VIX above.  All of the $VIX spike peak buy signals for 2014 are marked on the chart.  There were eight signals, including the latest one which is still open.  Six were profitable – some by quite a large margin.  

The other two signals  (marked in blue on the chart on page 11) were not profitable; they were both stopped out when $VIX rose to a higher high.  As of the close on December 23rd, the most recent signal was up 92.5 points.  Using that figure, the eight signals produced a gain of 335 $SPX points during 2014, or an average of 41.9 points per signal.  I don’t have the data compiled in terms of an option purchase, but since we buy at-the-money options, with a duration of one month or more, and since we are out of the trade after 22 trading days at most, option purchases clearly did well also. 

“modified Bollinger Bands” (mBB)

mBB signals occur when $SPX exceeds +/–4-sigma (σ) from its 20-day moving average and then moves back inside the corresponding +/–3σ Band.  Both buy and sell signals can occur.  

Please refer to the chart of $SPX above, for all of the mBB signals in 2014. 

In designing this system, we were hard-pressed to find an “optimum” stop.  The best result is when $SPX trades all the way from the signal to the opposite 4σ Band.  That terminates the signal for a profit.  It’s the signals that wander in between that are more difficult to quantify.  

As you see, there were six signals last year.  Three of them – one buy and two sells – traded all the way through to touch the opposite 4σ Band.  The latest signal, a buy signal from early December, is off to a good start as well. $SPX would have to rise to about 2130 in order to the current +4σ Band to be touched, thus terminating that buy signal at a large profit.

The two losses were both sell signals (marked in blue), where the market just meandered sideways to slightly higher.  But if one owned options, he would have lost a large percentage on such a trade.

The six trades produced a total profit of 260 $SPX points, or an average of 65 points per trade.  This marks the current trade at $SPX 2082.17 (Tuesday’s close).  Calculated in percentage terms, the six signals added up to a gain of 13.4% in $SPX for the year.  Obviously, with options, the percentage gain would have been much larger.

Total  Put-call Ratio

The total put-call ratio gives rare buy signals after extreme oversold conditions.  Each buy signal targets a 100-point gain for $SPX.  There is also a secondary, short-term system, whereby one-day oversold reading generate one-day buy signals.

Let’s address the longer trade first, since it is the real objective of this system.   There was only one trade this year: we bought $SPX on October 28th, and $SPX fulfilled the 100-point rise by November 21st.   We rolled our long options up along the way.

The “official” (theoretical) signal came a few days later, on October 31st, and it is still open.  Its target is 2118.  But we used our actual trade, not the “official” trade in our track record and preformance data.

The single day Total put-call signals fall into two categories: 1) those that “qualify” under our system, and2) those that don’t.  Historically, category (1) far outeprforms category (2).  In 2014, however, the opposite occurred.  Category (1) lost 48 $SPX points, all of which occurred between October 9th and 15th, where $SPX dropped day after day, while generating a series of Total put-call ratio buy signals.  Meanwhile, category (2) – which we did not trade in any of our services – posted a gain of 53 $SPX points for the year (most of which occurred on one day: December 16th, when $SPX was up 40 points).  Regardless, we are not changing the parameters of these systems at this time, although we may revisit the subject if this more recent trend persists.

Oscillator Differential

This system activates when our two breadth oscillators – “stocks only” and NYSE – differ by at least 300 (NYSE minus “stocks only”).  A buy signal occurs when the two oscillators begin to converge again, with the differential below 250.  Typically signals from this system come in bunches, with several false starts before a strong, longer-lasting buy signal occurs.  The signals are best treated as short-term signals, despite the fact that doing so means you won’t capture the large gains of the last signal in the sequence.

In 2014, there were two “bunches” of signals.  The first was a series of eight buy signals from March 28th through May 21st.  The second was a series of three signals from Oct 2nd to October 14th.  

The first bunch was profitable for one-day holding periods, but not for longer periods.  The second bunch was much more profitable, with every holding period of 5 days or longer producing a profit.  

Taking a larger view, I’d rate the first series of signals as a loss, but the second as a gain – even a strong gain.  Of course, in the time frame of mid-October, we had a lot of other buy signals as well.

Volatility Crossover

This system centers on the relationship of $VIX and $VXV.  This system – like many of the others – has two facets: when $VIX crosses above $VXV, one can short the market, and when $VIX later crosses back below $VXV, one can buy the market.  They sometimes come in groups or “bunches.”   

The buy signals generated during 2014 were quite successful.  There were 8 of them, some of wihich were “bunched.”  Counting all 8, profits were made for all holdings periods from one day  up to 90 days.  

The sell signals were not profitable, though, although the losses were small, and we only made one official short sale trade because of the system.  Perhaps this part of the system needs more analysis, or maybe it was just too much of a bull market year for a short selling system to show a profit.

In summary, these systems performed well in 2014, and we have every reason to expect they will continue to do so in 2014.

This aticle was featured in the most recent edition of The Option Strategist Newsletter.