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Posts Tagged ‘IWM’

Are Overbought-Oversold Indicators Reliable Predictors of Short-Term Market Performance – a 100-Week Backtest

Thursday, March 12th, 2015

This week I would like to report on a study I recently made for Terry’s Tips paying subscribers.  I checked out the validity of a popular way of predicting whether the short term market might be headed higher or lower.   I think you will find that the results are astonishing.Terry

Are Overbought-Oversold Indicators Reliable Predictors of Short-Term Market Performance – a 100-Week Backtest

One of the most popular indicators in many analysts’ toolbox is the overbought-oversold numbers generated by the current RSI.

I have never figured out how to get reliable information from reading charts, although many people apparently find them useful.  The same goes for the overbought-oversold indicators.  On the other hand, I know that many people believe in these numbers, and every Saturday for over ten years, I have published these indicators for SPY, DIA, IWM, and QQQ for subscribers to my options newsletter, Terry’s Tips.

Each week, we average the 2-day, 3-day, and 5-day RSI numbers for these popular ETFs and used the following ranges to determine where the ETF stood at the close on Friday:

Very overbought – an RSI reading of greater than or equal to 85.0
Overbought – greater than or equal to 75.0
Neutral – between 30.0 and 75.0
Oversold – less than or equal to 30.0
Very oversold – less than or equal to 20.0
Extremely oversold – less than or equal to 10.0

Last Friday, March 6, both SPY and DIA were “Very Oversold” and IWM and QQQ were “Oversold.”  This prompted me to wonder what that might mean for the market this week.  Were these numbers significant indicators or not, I wondered?

I went back and checked the results for the last 100 weeks from my Saturday Reports.  Here are the numbers for SPY, perhaps the best measure of “the market:”

Neutral – 47 weeks
Overbought – 16 weeks
Very Overbought – 22 weeks
Oversold – 5 weeks
Very Oversold – 8 weeks
Extremely Oversold – 2 weeks

A little less than half the time (47%), the reading was neutral.  In 38% of the weeks, SPY was overbought or very overbought, and in 15% of the weeks, it was in some sort of oversold condition.

I then checked out how SPY performed for the subsequent seven days. Here are the numbers showing what happened to SPY in the week following the condition reported in each Saturday Report:

overbought oversold chart march 2015

overbought oversold chart march 2015

When SPY is overbought, the technicians would expect that the market would be weaker in the next week, but just the opposite was true.  In fact, in 81% of the weeks when it was overbought, SPY rose in the subsequent week.  It also went up in 64% of the weeks when it was very overbought.

Clearly, being overbought or very overbought is an absolutely worthless indicator of a lower market.  In fact, in subsequent weeks, for the most part, the market outperformed.  If the market rose by the average percentage when it started out either overbought or very overbought every week of the year, it would go up by over 61% for the year.  In other words, being overbought or very overbought is an excellent chance to bet on a higher market for the next week (rather than the opposite).

The oversold condition is an entirely different story (based on the last 100 weeks).  Being oversold or extremely oversold is essentially a meaningless indicator – the market rose or fell in just about the same number of weeks following one of those conditions.  However, being very oversold seems to be an excellent indicator of a higher market.  In 83% of the weeks when it was very oversold, it rose in the subsequent week.  The average market gain in those weeks was 1.21% (62% annualized).

Another interesting result is that anytime SPY is anything except neutral, it is a decent indication that the market will move higher in the next week.  Being very oversold is the best positive indicator, but being overbought is almost as good a positive indicator (even though this is absolutely contrary to what many technicians would expect).

Last Friday, SPY was very oversold.  That occurs in only 8% of the weeks, and for the past 100 weeks, the market was higher 83% of the time in the subsequent week.  As I write this before the market opened on Thursday, so far, SPY has dropped by exactly $3 (1.45%).  This time around, it looks like even the historically most reliable indicator is not working as expected, either.

Bottom line, if you are trying to get a handle on the likely one-week performance of the market based on the overbought-oversold condition on Friday, you are bound to be disappointed. These indicators just don’t work, except possibly the very oversold indicator (and this week is a reminder that even this one is not always right, either).  Maybe the results would be different if you checked on the one-day or two-day changes rather than the one-week variations, but that is something for someone else to check out.

Volatility’s Impact on Option Prices

Monday, April 28th, 2014

Today I would like to talk a little about an important measure in the options world – volatility, and how it affects how much you pay for an option (either put or call).

Terry

Volatility’s Impact on Option Prices

Volatility is the sole variable that can only be measured after the option prices are known.  All the other variables have precise mathematical measurements, but volatility has an essentially emotional component that defies easy understanding.  If option trading were a poker game, volatility would be the wild card.

Volatility is the most exciting measure of stock options.  Quite simply, option volatility means how much you expect the stock to vary in price. The term “volatility” is a little confusing because it may refer to historical volatility (how much the company stock actually fluctuated in the past) or implied volatility (how much the market expects the stock will fluctuate in the future).

When an options trader says “IBM’s at 20” he is referring to the implied volatility of the front-month at-the-money puts and calls.  Some people use the term “projected volatility” rather than “implied volatility.”  They mean the same thing.

A staid old stock like Procter & Gamble would not be expected to vary in price much over the course of a year, and its options would carry a low volatility number.  For P & G, this number currently is 12%.  That is how much the market expects the stock might vary in price, either up or down, over the course of a year.

Here are some volatility numbers for other popular companies:

IBM  – 16%
Apple Computer – 23%
GE – 14%
Johnson and Johnson – 14%
Goldman Sachs – 21%
Amazon – 47%
eBay – 51%
SVXY – 41% (our current favorite underlying)

You can see that the degree of stability of the company is reflected in its volatility number.  IBM has been around forever and is a large company that is not expected to fluctuate in price very much, while Apple Computer has exciting new products that might be great successes (or flops) which cause might wide swings in the stock price as news reports or rumors are circulated.

Volatility numbers are typically much lower for Exchange Traded Funds (ETFs) than for individual stocks.  Since ETFs are made up of many companies, good (or bad) news about a single company will usually not significantly affect the entire batch of companies in the index.  An ETF such as OIH which is influenced by changes in the price of oil would logically carry a higher volatility number.

Here are some volatility numbers for the options of some popular ETFs:

Dow Jones Industrial (Tracking Stock – DIA) – 13%
S&P 500 (Tracking Stock – SPY) –14%
Nasdaq (Tracking Stock – QQQ) – 21%
Russell 2000 (Small Cap – IWM) – 26%

Since all the input variables that determine an option price in the Black-Scholes model (strike price, stock price, time to expiration, interest and dividend rates) can be measured precisely, only volatility is the wild card.   It is the most important variable of all.

If implied volatility is high, the option prices are high.  If expectations of fluctuation in the company stock are low, implied volatility and option prices are low.  For example, a one-month at-the-money option on Johnson & Johnson would cost about $1.30 (stock price $100) vs. $2.00 for eBay (stock price $53).  On a per-dollar basis, the eBay option trades for about three times as much as the JNJ option.

Of course, since only historical volatility can be measured with certainty, and no one knows for sure what the stock will do in the future, implied volatility is where all the fun starts and ends in the option trading game.

Three New (Weekly) Options Series Introduced

Tuesday, November 20th, 2012

The world of stock options is every changing.  Last week, three new series of options were introduced. Options trades should be aware of these new options, and understand how they might fit into their options strategies, no matter what those  strategies might be.

Three New (Weekly) Options Series Introduced

Last week, the CBOE announced the arrival of several new options series for our favorite ETFs as well as four individual popular stocks which have extremely high options activity.

Here they are:

For the above entities, there are now four Weekly options series available at any given time.  In the past, Weekly options for the following week became available on a Thursday (with eight days of remaining life).

This is a big change for those of us who trade the Weeklys (I know that seems to be a funny way to spell the plural of Weekly, but that is what the CBOE does).  No longer will we have to wait until Thursday to roll over short options to the next week to gain maximum decay (theta) for our short positions.

The stocks and ETFs for which the new Weeklys are available are among the most active options markets out there.  Already, these markets have very small bid-ask spreads (meaning that you can usually get very good executions, often at the mid-point of the bid-ask spread rather than being forced to buy at the ask price and sell at the bid price).  This advantage should extend to the new Weekly series, although I have noticed that the bid-ask spreads are slightly higher for the third and fourth weeks out, at least at this time.

The new Weeklys will particularly be important for Apple.  Option prices have traditionally sky-rocketed for the option series which comes a few days after their quarterly earnings announcements.  In the past, a popular strategy was to place a calendar or diagonal spread in advance of an announcement (further-out options tend to be far less expensive (lower implied volatility) than those expiring shortly after the announcement, and potentially profitable spreads are often available.  The long side had to be the newt monthly series, often a full three weeks later.

With the new Weekly series now being available, extremely inexpensive spreads might be possible, with the long side having only seven days of more time than the Weeklys that you are selling.  It will be very interesting come next January. 

     Bottom line, the new Weekly series will give you far more flexibility in taking a short-term view on stock price movement and/or volatility changes, plus more ways to profit from time decay.  It is good news for all options traders.

 

 

An Interesting Post-Expiration Play

Monday, July 30th, 2012

Last week we made a little trade that doubled our investment in one day.  Every month, a similar opportunity presents itself.  Of course, it doesn’t always work out this nicely, but it seems to do well most of the time.  Today, I would like to share our thinking with this trade.

An Interesting Post-Expiration Play

Many investors are aware of a couple of phenomena which seem to prevail in the market.  The first is that the Monday after the regular monthly options expiration is generally a weak day for the market.  The second is that the first trading day of each month is usually a strong day.

When other indicators also suggest that these generalizations might hold true, it might be a good time to make the outright purchase of a put or call.

On Friday, July 20, the regular monthly options expired.  At that time, the market was also in an overbought condition (one of the indicators that we follow, RSI, was over 70).  Overbought conditions are not nearly as important indicators as are oversold conditions, but they are something to consider nonetheless.

Our favorite ETF to use when buying options is the Russell 2000 Small-Cap (IWM).  It seems to fluctuate in the same direction as SPY, but by larger percentages.  On expiration Friday, with IWM trading right around $79, we bought a Jul4-12 Weekly 79 put for $.85.  Actually, we bought 5 of them, shelling out $425 plus $6.25 for commissions (our broker, thinkorswim, charges Terry’s Tips subscribers a flat $1.25 per option contract).

On Monday, we placed a limit order to sell those puts if the price got up to $1.73.  The stock tumbled almost $2 on that day, and our order executed.  We were delighted to double our money after paying the commissions.  After commissions, we made a profit of $427.50 on our initial investment of $425.

We could have made more if we had waited a little longer, but we’ll take double our money any day.  Selling when we did ultimately proved to be a good idea because by the end of the week, our puts expired worthless when the stock rose to above $79.

Last week was a great one for anyone who bought either puts or calls.  Option prices were low (lower than they are this week) and volatility was high.  If you were willing to accept a moderate profit on your option buy, you could have done well either with puts or calls last week.

For most of the past couple of months (and all of last summer as well), option prices have been lower than the actual volatility of the market (SPY, and IWM).  This means that a good strategy has been to buy options rather than sell them (which is our usual preference).

This week, the first trading day of August falls on Wednesday.  We might be inclined to buy a call on IWM because the market is often strong on that day.  However, option prices (VIX) rose 5% Monday morning so options are not quite so cheap this week.  With the big run-up in the market last Friday (SPY gained almost 2%), we are probably due for some weakness soon, so we are probably not going to buy a call this time around.  We like to see other indicators which support our buying decision, and we don’t see any at this point in time.  (RSI is neutral, for example.)

Buying options is still probably a good short-term idea, but sometimes it is safer just to sit on the sidelines for a week or so and wait for a more opportune time.

Another Buying Straddles Story

Monday, July 16th, 2012

For most of the last year, the market (SPY) and many individual stocks have fluctuated more than the implied volatility of the options would predict.  This situation has made it quite difficult to make gains with the calendar spread strategy that we have long advocated.

Now we are experimenting with buying straddles as an alternative to our basic strategy.  This represents a total reversal from hoping for a flat market to betting on a fluctuating one.

Today I would like to report on a straddle purchase I made last week.

Another Buying Straddles Story

I selected the Russell 2000 (Small-Cap) Index (IWM) as the underlying. For many years, this equity seems to fluctuate in the same direction and by about the same amount as the market in general (SPY) although it is trading for far less ($80 vs. $134) so the percentage fluctuations are greater.

On Monday morning, IWM was trading right about $80. I bought an 80 straddle using IWM (Jul2-12 puts and calls), paying $1.53 for the pair.  If IWM moved by $1.53 in either direction, the intrinsic value of either the puts or calls would be $1.53, and there would be some time premium remaining so that either the puts or calls could be sold for a profit.

How likely was IWM to move by more than $1.53 in either direction in only one week?  Looking back at weekly price behavior for IWM, I found that in 62 of the past 66 weeks, IWM had fluctuated at least $1.60 during the week in one direction or another.  That is the key number I needed to make the purchase.  That meant that if the historical pattern repeated itself, I could count on making a profit in 94% of the weeks.  I would be quite happy with anything near that result.

Buying a straddle fits my temperament because I was not choosing which way the market might be headed (something I know from experience that I can’t do very well, at least in the short term), and I knew that I could not lose 100% of my investment (even on Friday and the stock had not moved, there would still be some time premium remaining in the options that could be sold for something).

One on the biggest problems with trading straddles is the decision on when to sell one or both sides of the trade.  We’ll discuss some of the choices next week.  What I did was place a limit order to take a reasonable profit if it came along.  When IWM had fallen about $1.75, I sold my puts for $1.85 on Thursday.  On Friday the stock reversed itself, and I was able to collect $.17 by selling the calls, making a total 20% after commissions for the week. Not a bad result, I figured.  

At some point during the week, there were opportunities to sell both the puts and calls for more than I sold them for, but I was delighted with taking a reasonable profit.  You can’t look back when trading straddles.  If I had not sold the calls but waited until the end of the week, I would have lost about 70% of my original purchase.  So selling when you have a small profit is clearly the way to go.

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