How to Trade Using Market Timing Signals

| December 12, 2011 | 0 Comments

Strategies for trading can and should vary depending on the type of market timing system and each trader's individual goals.  AF Capital Management’s market timing system is based on technical analysis, specifically trend following, and is not meant for day traders.  Investors can use different approaches to reach varying goals.  With any of these approaches, investors can use either regular index ETFs such as SPY, MDY and IWM or can take on more risk for potentially higher reward with ultra ETFs such as SSO, MVV and UWM which attempt to produce double the daily return of the index they track.

The most straight forward method is to buy, sell and hold each ETF based on the trade signal issued. This allows for maximum gains in longer trend cycles, but can be less profitable in markets that whipsaw traders or when a market moves sideways for extended periods. Inverse ETFs can be bought in accounts (such as IRAs) that do not allow short positions.  This type of investor wants to get every possible penny out of each price swing.

A slightly less active variance on the buy, sell and hold approach is to only trade a portion of one's account with each trade signal.  Some investors prefer not to use short positions (or inverse ETFs).  They buy 100% of their allocation when a buy signal is in place.  When a neutral signal is issued they only sell 50% of the position and then sell 100% of the position and remain in cash when a sell signal is issued.  These investors do not open short positions based on the belief that markets tend to go up over time and they will be patient in cash rather than be short when a spike in price hits.  This type of investor believes he/she will make enough profit on the long side (and will beat the indexes) if he/she misses most of the downside.

Investors who are familiar with the complexities of investing with options and are looking for less volatility often use put and call options to cushion both sides and profit in sideways markets.  These investors can either buy or sell puts and calls based on each trade signal.  Each method has its own advantages and disadvantages.

Option sellers profit the most in a sideways market.  They sell front month naked puts in-the-money when a buy signal is issued.  This gives some cushion to the downside in the event the signal is not accurate to the day.  If they are forced to buy they do so at a discount to the market.  Selling puts limits upside potential based on how far in-the-money the put's strike is and how much is received in premiums.  If the investor is already long the ETF, then he/she can stay long and not sell any new options.  An option seller sells covered calls in-the-money or at least at-the-money when a sell signal is issued.  Although this reduces upside potential it also reduces the average cost per share and increases the probability of creating a better return than the underling ETF over time.  A major disadvantage of this approach is that although losses are reduced, the downside risk is not limited during a bear market.  The ideal investor to use this strategy is one whose goal is simply to beat the indexes' returns.  These investors like higher probability trades because they profit when the index moves in their direction and when it moves sideways.  To increase the probability of having a profitable trade (albeit at a lower return) an option seller can move the strike further out of the money.

An option seller can take another approach too.  A trader can sell new naked puts on an inverse ETF instead of selling covered calls (or in addition to covered calls) when a sell signal is issued.  This approach generally attempts to never take ownership of ETF shares, but only take frequent small profits from the options when the market shifts in either direction.  A trader can sell naked puts on both bullish and bearish ETFs when a neutral signal is given with the goal of profiting on both sides.  Typically each strike should be farther out-of-the-money than when trading on buy and sell calls to avoid assignment on slight gyrations in either direction.

Option buyers profit the most when the price swings between trade signals is more severe.  Slow ascents and descents often do not give long options enough change in price to overcome time value decay.  Option buyers purchase calls when a buy signal is issued and buy puts when a sell signal is issued.  Option buyers do not trade when a signal is issued as neutral, unless it is to close any open positions that may not gain any more value.  An option buyer can make the most money when using leverage to multiply gains with less downside risk.  The downside risk can be 100% if the market moves against the trader's position unexpectedly.  For this reason, only experienced options investors who understand how to hedge risks or limit exposure should buy options.

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Filed Under: Investing 101


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