SPY "noise" trading?

The "random walk" of the market, is just another way to say "noisy" walk. Daily increase and decrease of prices usually trace out a path that is very similar to the volume of the hiss that you get from a radio tuned to a channel with no stations. One difference is that markets also have "drift" -- they tend to go up or down at a longer time scales based on macro economics, wars, fear & greed, and who knows what else. For reasons that are not clear to me, the magnitude of the "noise" on a market tends to be proportional to the square root of the time span. For example if the magnitude of the annual noise is 12%, the daily noise will tend to be around 12% divided by the square root of the number of trading days in the year -- about 250. The square root of 250 is about 15.8, so the daily change in this example would be 12%/15.8 or around %0.76 The minute to minute variations are predicted to be 12%/346 (square root of 250*8*6) = ~ .035%. On the Spy S&P 500 index this would be around 4 to 5 cents. Eyeballing the charts for daily and by minute high vs. low these predictions look pretty close.

So is there a way to take advantage of this level of predicted noise, without having to guess which way the market will "drift"? I think not, because if people had figured this out they would be writing books about it while sitting on their decks in Maui.

The big challenge is to avoid getting caught if the market drifts in a direction contrary to your position. Let's say you buy SPY at opening at $130 with a sell order set at $130.99 (0.76% higher). The theory would predict that you would succeed with this strategy about 50% of the time on the 1st day. If the market is "going sideways" with no clear overall trend or trending up, the odds are very good that you would close out your order successfully within a few days. However, if the market decides to tank at that point you may have to wait a very long time for your sell order to execute. So is there a cost effective way to collect the likely day-to-day gains but not get wiped out if the market tanks? One approach would be to buy puts at the current support level of the trading range. If the market tanks you have at least limited the potential damage. Your loss would be the difference between your buy-in price and the put strike price and the put option premium. Another approach would be to hedge with $VIX volatility options which tend to go up when the market goes down. These have the advantage that they are profitable if the market drops suddenly, regardless of what prices the SPY index is selling for.

Data on $VIX options (Volatility) and interest rate options

• $VIX Expiration Date:
  In most months VIX options expire the Wednesday before equity options expire. Some months however they expire on the Wednesday after the 3rd Friday of the month -- which is generally when equity options expire)
  

Reference http://www.cboe.com/Products/indexopts/vixoptions_spec.aspx


Interest Rate Options Product Specifications

Symbols:
13-Week Treasury Bill - IRX
5-Year Treasury Note - FVX
10-Year Treasury Note - TNX
30-Year Treasury Bond - TYX

Underlying:
IRX is based on the discount rate of the most recently auctioned 13-week U.S. Treasury Bill. The new T-bill is substituted weekly on the trading day following its auction, usually a Monday. FVX, TNX and TYX are based on 10 times the yield-to-maturity on the most recently auctioned 5-year Treasury note, 10-year Treasury note and 30-year Treasury bond, respectively. Options are European style exercise.

Dividend Trading -- what I learned this summer

What I learned this summer is that my dividend trading approach (buying stocks right before ex-dividend, and hedging by selling relatively deep in the money calls) works most of the time. Unfortunately it does not successfully handle the negative side of the "long tail" of market volatility. The long tail refers to the market's tendency to become much more volatile than normal at times--more often than the standard "normal" distribution would predict. I was caught with large positions in several stocks where the options were not assigned at the ex-dividend date (which is normally a good thing because I obtain the dividend with a good call option hedge), but then the overall market went into a nose-dive that ate up my 5% to 10% buffer on the stocks and promised significant loses if the stock continued to tank. I bailed out in both cases before my stock went out-of-the-money on the option, but I still took losses that will take a long time to recoup with the standard dividend trading sorts of returns. In both cases I would have been alright if I had held on, but one of my primary goals with dividend trading is to avoid the necessity to predict the direction a stock is going to go. This stress is something I don't need. Watching 2300 shares of the stock go up and down several points day (FCX) near my option strike price is not good for my blood pressure.

As always the market is very good at preventing free lunches and it requires significant risk taking to even have a reasonably priced lunch. I have spent some time looking for ways to avoid this risk, including stock futures, but so far I have not found anything that works to protect against the negative long tails without reducing the rate of return to CD levels. The opportunities that are still worth a look are the ones where the stock option expiration is only a few days after the ex-dividend date. Unless really dramatic things happen then the risk looks reasonable. The problem with these situations is that the premium available on the option is low, and the option is more likely to be assigned because there the premium available is low. The other thing I want to look at is whether the gains from the short option in a market sell off could be use to finance enough futures contracts to hedge the overall position successfully without killing the rate of return. One fairly promising approach would be to buy $VIX calls to hedge the negative long tail scenario. A quick look at the 2300 share FCX situation I held in July indicates that just a couple of $VIX $12.5 calls would have protected the position.