The main advantage of active management vs. “buy and hold” is that traders have the potential to outperform the index. If they believe the market might turn downward, active traders can take defensive measures by hedging, going to the sidelines, or increasing their cash positions to reduce the impact on their holdings. For example, had you bought the S&P500 index and held it for one year (as of 4/22/2015), an initial investment of $10k would have appreciated to $11,211. Along the way, you would have experienced a 159 point drop in the index, about an 8.5% draw-down. Those are the results of the common “buy and hold” strategy. Contrasting, had you invested $10k and moved in and out of the market based on Itrac’s signals, your initial investment would have appreciated to $12,188. Even better, your worst draw-down would have been only 55 index points, or about 1/3 of the draw-down of the “buy and hold” strategy. Over the recent one year (250 trading days) period ending 06/09/15, “buy and hold” returned 7.9%, while Itrac returned 21.2%. (Transaction costs not included.)
A key component of Itrac’s strategy is to avoid draw-downs by signaling when you should move to the sidelines. A logical outcome of that kind of strategy is improved returns.
To trade Itrac’s forecast, you must first choose an appropriate trading instrument. Two examples are given here: the E-mini futures contract and the SPY index ETF. Individual stocks or baskets of stocks which are correlated to the index may also be used as the trading instrument. See the following links for more information:
SPDR S&P 500 ETF Trust (SPY)
1. Liquidity and Access – The SPY is an extremely liquid product that is easily accessible by most any retail-trading platform. Whereas some online brokers do not offer access to futures trading, the SPY serves as a nice alternative to the E-mini S&P.
2. Smaller Denominations – Unlike the E-mini, the SPY is priced in much smaller denominations (roughly $210.00 at the time of this writing, or about 1/10 the S&P 500 index), they are particularly attractive for those who are not as interested in controlling upwards to 500 shares of the fund, which is what the E-mini roughly equates to.
3. Easy to Comprehend – With the SPY structured much like a stock, and traded in the same venue, it is no surprise that the retail trader has adopted this instrument with open arms, as the perceived learning curve is much less than the E-mini.
4. ETFs are flexible and easy to trade. Investors buy and sell them like stocks, typically through a brokerage account. Investors can also employ traditional stock trading techniques; including stop orders, limit orders, margin purchases, and short sales using ETFs. They are listed on major US Stock Exchanges. ETFs are subject to risk similar to those of stocks including those regarding short-selling and margin account maintenance. Ordinary brokerage commissions apply.
E-mini S&P 500
1. Liquidity – The CME Group noted in their 2012 report that the E-mini S&P contract traded, on average, $142 billion in transaction dollar volume per day versus a $18.5 billion that the SPY trades.
2. Execution – E-mini’s are traded nearly 24/7 during the weekdays on the CME Globex system, whereas the SPY is only traded during normal and extended US exchange trading hours (6am-8pm EST).
3. Leverage – In trading futures the margin requirements are different from those in the equity markets. The SPY, which is traded in the equity market and thus falls under equity market margin requirements, will be subject to Regulation T margin requirements (portfolio margin not assumed). This means one must place an initial 50% deposit down on the transaction, equating to a 2:1 leverage ratio. However, with the E-mini S&P the margin requirement is met via a performance bond that secures the transaction. For every contract, which has a nominal value of $100,000 assuming we purchase the contract at 2,000 ($50 x 2,000), the initial requirement is about $5,000 (subject to adjustments). This equates to a deposit of 5.0% of the nominal value of the underlying. Therefore, it is apparent that E-mini’s offer far more leverage than the SPY, however also understand that with leverage can come both good and bad outcomes. While your returns can be enhanced via leverage, so too can your losses.
4. Tax Benefits – For the short-term trader (less than 1 year) trading the E-mini might provide distinct tax advantages over the SPY as they are classified differently by the tax code. With the SPY you only initiate a taxable event when you liquidate your position, which will then incur a capital gains tax based on the time horizon of your holding. So for those whose time horizon on a trade is less than one year, your capital gains would be taxed at your personal income tax rate. In contrast, index futures fall under US tax code 1256 where gains and losses are marked to market at the end of every year. In this scenario time horizon is not a factor, as realized and unrealized capital gains/losses are lumped together, regardless of time held, with 60% of the gains is treated as long term and 40% as short term.
5. Commissions – Generally speaking, commissions on a futures trade are less when compared to a comparable trade in nominal dollar size in the SPY.
Calculating Position Sizes
Ask yourself, “What is the largest draw-down in dollars that I could comfortably tolerate?” My experience has been that traders almost always give a larger number than they practically are comfortable with. When faced with the inevitable trading draw-down, the majority of traders throw in the towel before they reach their maximum draw-down tolerance. Be conservative with this estimate, perhaps taking only half of what you thought you might be comfortable with.
Let’s assume I estimated my largest comfortable draw-down at $10k. Half of that is $5k. When calculating appropriate position sizes, one should first estimate the largest likely system draw-down over any time frame. Let’s say that looking at past returns volatility, a trading system had a maximum draw-down of 400 S&P 500 “Big Points”, i.e. the S&P 500 index fell from 2000 to 1600 for example. If I had chosen to trade the SPY ETF, a single share would have lost about one tenth of that, or $40.00. Since my comfortable draw-down tolerance was estimated at $5k, I could have traded 125 SPY’s for a maximum draw-down of $5k. The second constraint on position size is you capital availability.
If you put on a full 125 SPY’s when the S&P500 was at 2000, your cost would be approximately 125 times (for example) $200.00, or $25k. Even if your broker allows 50% margin, it would still cost over $12.5k to establish that position, plus margin requirements (talk to you broker about margin accounts and requirements.) If you can only afford a $10k trade, you would have to limit your SPY quantity to 100, (100 times $200.00 = $10k with 50%margin). In this case, your position size is limited by available capital, not draw-down tolerance. Either capital availability or risk tolerance will limit your position size.
That is just one example of how one might choose to estimate maximum position size. Remember that past draw-downs aren’t always the best measure of future draw-downs, so use an effective safety factor when calculating your position sizes. Remember also that index price change distributions may not be normally distributed.
The hardest part is estimating the likely future price change of the index. IntelliTrade helps with that. Estimating position size is the second most difficult part. The last part, and likely the easiest, is to open an account and start trading.
There are many brokers, on-line trading platforms and mobile apps available to trade SPY’s or E-mini’s. TD Ameritrade has an app for the iPhone. Just google “Broker” for a list of brokers. They are all very happy to help you set up an account and begin trading. After you set up an account (and/or margin account), just monitor each evening the IntelliTrade web site for the latest forecast. Next morning, if necessary, contact your broker (or trade on-line or mobile) and adjust your holdings appropriately. You may scale into or out of SPY’s, E-mini’s, stocks, or other correlated instruments based on information provided by IntelliTrade and other sources, adjusted for your specific financial situation. For example, if IntelliTrade changes forecast to “FLAT” for the next day, you might sell some or all of your long positions, reducing or eliminating your exposure to a potentially falling index.
Risk Tolerance and Risk Capital Considerations
It is prudent to begin new ventures with some degree of caution, and trading or investing is no different. Always remember the old cliché and strive for “preservation of capital.” It only makes sense to take on the appropriate risk for your situation if the worst-case scenario will leave you able to live to fight another day.