TimingCube - Implementing the TimingCube strategies with options - QQQQ call,QQQQ put,expiration month,strike price,CBOE,optionsXpress

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Signal Update

Current Signal Performance as of

Signal Type	Trade Date	Index	Return since issued
		Nasdaq 100
		Russell 2000
		S&P 500
		QQQQ

Cumulative Returns since First TimingCube Live Signal () as of

Index	Long Only	Long Only with Margin	Long & Short	Long & Short with Margin	Buy & Hold
Nasdaq 100
Russell 2000
S&P 500
QQQQ

Note: QQQQ returns are included for continuity sake.

Market Update

Despite a brief pause Thursday, in part caused by Amazon.com's worse-than-expected earnings report, markets marched higher this week and finished with big gains on Friday. The Dow, the S&P 500 , the Russell 2000 and the Nasdaq Composite have now recovered a sizable portion of their January losses and are all back above their respective 50-day exponential moving averages (EMA). In fact the S&P 500 is only less than one percent away from its December closing high. For the week, the Russell 2000 gained 3.99% while the S&P 500 moved 2.70% higher. The Nasdaq 100 , which has faced the most pressure since early January, trailed a bit but still gained a respectable 2.34% on the week.

With markets on the rebound, our current Buy signal remains in effect.

Trend Timing School

Implementing the TimingCube strategies with options

The last two Trend Timing School installments established a common base of understanding about options investing and terminology. The suspense is finally over, and we can now proceed to the main course which is how to implement our four strategies with options. Specifically, we will present how options can offer a very effective substitute for short selling and margin trading while at the same time reducing our market risk. Furthermore, the securities and techniques described here, being authorized in IRAs, provide such retirement accounts with viable alternatives to the bull/bear mutual funds we were forced to use for anything but the Long Only strategy. Note that since brokers make their own rules and regulations, some of them may not allow such instruments or transactions in your account, so make sure to check with yours directly.

The examples provided in the table below illustrate the steps for both Buy and Sell signals, and compare the options scenarios with the corresponding equity approach. As you would expect, we use QQQQ as the guinea pig, and apply the real prices as of this morning. You can find option quotes on many sites but we like optionsXpress where you can easily enter a ticker symbol directly on the home page and click "Chain" in order to get the entire list (also called chain) of strike prices and expiration dates for the underlying interest (QQQQ in this case). The CBOE web site which we mentioned a couple of weeks ago also provides a very complete Symbol Directory for equity options, index options and LEAPs.

Selecting the type of option transaction. To initiate a position on a Buy signal we will buy a QQQQ call option contract which gives us the right to buy 100 shares of QQQQ, at the selected strike price, before the expiration date. As you will see below, our intention is not to acquire the QQQQ shares by exercising the option but rather to gain by selling the option at a higher price. Buying the call option is similar to buying QQQQ because its value will increase when the price of QQQQ rises and drops when QQQQ falls.
Conversely, in the case of a Sell signal we will buy a QQQQ put option contract which gives us the right to sell 100 shares of QQQQ, at the selected strike price, before the expiration date. Again, we have no intention of selling QQQQ shares. The net effect of a put option is similar to selling QQQQ short because if the price of QQQQ drops, our option will be worth more, and vice versa.

Selecting an expiration month. There is a broad spectrum of option expiration date choices ranging from the extremely short-term (i.e. a February 2005 option), to LEAPs which can have expiration dates of up to three years out. However, since the TimingCube Model issues signals an average of about three times per year, for average trade durations of about four months, the most appropriate options for our strategies are the ones expiring about six months out. From February, six months brings us to August which is not an available choice since option expiration months only occur every three months, starting in January. This leaves us with a choice of June or September. Since we never want to hold an option during its expiration month, the June options would only give us an effective holding period of three months which is cutting it too short for our taste. So we select the September 2005 expiration options.

Selecting a strike price. The September 2005 option strike prices currently range from $27 to $47, offering a selections from deep in-the-money to severely out-of-the money. There are many option investing styles and preferences but for our purposes we like the options that are slightly in-the-money (10% to 15%). This corresponds nicely to the possible drawdowns of our Model, but also tends to be easier on emotions by not being in the red at the slightest pullback, or even due to the shrinking time value. In-the-money options are more expensive to buy but they carry intrinsic value. For a call option, strike prices below the underlying interest price are in-the-money, while for puts, strike prices above the underlying are in-the-money.
In our example, in order to find the strike price for the call options in the Buy signal scenario, we multiply $37.15 (the price of a QQQQ share at yesterday’s close) by 0.9, and select the nearest strike available: $33. For the put options in the Sell scenario, we multiply $37.15 by 1.1, and select the closest strike: $41. Looking up these strike prices for the September 2005 QQQQ calls and puts, we obtain the respective symbols QAVIG and QQQUO.
In this example, the price of the call option is more expensive than the put option ($5.60 versus $4.20) for a couple of reasons. First, the call is slightly deeper in the money with an intrinsic value of $4.15, versus $3.85 for the put. As can be seen in the table, the call also has a much higher extrinsic value (also called time value) of $1.45 versus $0.35 for the put. The extrinsic value is a function of the duration remaining until expiration but also of investor expectations. The current "surcharge" for the call is a clear indication that investors are expecting QQQQ to go up in the coming months, matching the trend presently in effect in our Model.

Selecting the number of contracts to buy. In our example we have a $100,000 nest egg to invest. If we purchased (or shorted) the QQQQ shares without leverage, we would buy (or short) 2,600 shares ($100,000 / $37.15 rounded down to the nearest 100). To achieve a comparable return with options we would simply buy 26 contracts (each contract represents 100 shares). In our Buy signal situation, we would buy 26 QAVIG call option contracts for $14,560, and for a Sell signal, we would buy 26 QQQUO put option contracts for $10,920.

Applying leverage. Now that we have the basic mechanics down to emulate a Long and Short strategy, all that remains is to apply margin. Given that the 26 call or put options in our example will tend to move up and down at about the same rate as QQQQ does in dollar terms (except for the time value fluctuations), all we need to do to achieve the 2x leverage (full margin) of the Long and Short with Margin strategy is to buy double the number of contracts.

Monitoring and managing our position. Clearly, the intent is to keep the options until the next signal, at which time we would sell them for a profit if the market goes in the direction of our signal. However, we need to be on the lookout for signals of longer duration which could bring us close to our option’s expiration date. Since during the last month of an option the time value rapidly shrinks, you are increasingly unlikely to find a buyer at a good price. This is why we always want to sell the options no later than a full month prior to expiration (remembering that options expire on the third Friday of the month). After such a sale, we would then use the proceeds to buy another option as described above, and keep repeating the entire process until the next signal is issued.

Managing risk. Besides being able to replicate the effects of short selling and margin trading in our retirement accounts without having to resort to the bull/bear mutual funds, the example plainly illustrates the risk reduction that options can bring. Where trading the QQQQ shares potentially places all of our capital at risk (and possibly more if you short, as losses on short sales are theoretically infinite), trading with options only exposes between 10% and 15% of our capital (20% to 30% when seeking 2x leverage). In addition, the balance of our cash can be placed in interest bearing instruments such as money market or bond funds.

Comparing equity and option investing

Assumptions: - $100,000 starting capital
- Commissions not included
- QQQQ price is $37.15 (2/3/2005 closing price)

Buy Signal

Sell Signal

Using equities

Using options

Using equities

Using options

Type of option transaction

-

Buy QQQQ calls

-

Buy QQQQ puts

Type of equity transaction

Buy QQQQ shares

-

Sell QQQQ shares short

-

Selected expiration month

-

September 2005

-

September 2005

Selected strike price

-

$33
(37.15 x 0.9 = 33.44)

-

$41
(37.15 x 1.1 = 40.87)

Symbol

QQQQ

QAVIG

QQQQ

QQQUO

Option price (ask)

-

$5.60

-

$4.20

Intrinsic value

-

$4.15
($37.15 - $33)

-

$3.85
(41 - $37.15)

Time value (extrinsic value)

-

$1.45
($5.60 - $4.15)

-

$0.35
($4.20 - $3.85)

Contract price

-

$560

-

$420

Order placed

Buy 2,600 QQQQ shares

Buy 26 QAVIG

Sell short 2,600 QQQQ shares

Buy 26 QQQUO

Cost

$96,590
(2,600 x $37.15)

$14,560
(26 x $560)

$96,590
(2,600 x $37.15)

$10,920
(26 x $420)

Capital at risk

96.59%

14.56%

Infinite (theoretically)

10.92%

Since option investing is not an exact science, the numbers and figures used in the examples above can fluctuate, and the range of choices and permutations are nearly infinite. Use this article as a guideline only, and do not forget that you should never trade in instruments you do not fully understand, and always apply a solid dose of good judgment because it is not very difficult to outsmart yourself when trading options (e.g. "Why not buy options with my entire capital?" Because you will lose it all if the market goes against the signal, smart one!). If you like what we wrote about options but it made your head spin too fast, or you do not feel you are ready for the do-it-yourself approach, do not forget that our friends, the professionals at MarketTrend Advisors, can take care of the heavy lifting for you.

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