Buying a Moving Average, Part II

Discussion in 'Technical Analysis' started by jmsco, Nov 12, 2002.

  1. jmsco


    I started a thread last week about creating a proxy / synthetic position for a moving average. It attracted less than helpful responses and the moderator thankfully closed the thread. But lets give it another try.

    I was looking at different pair trading strategies recently and thinking about how for the most part everyone must be looking at the same set of pairs. As an alternative, is it possible to trade the spread between an index, say SPX/SPY/ES, and its own moving average, say a 13 day simple moving average for an example?

    To trade this spread it seems one would have to be able to identify when the spread has reached an extreme positive or negative value. You would also have to determine if there are levels at which the spread becomes so great that the probability of the spread collapsing in the near term becomes tradable. I would suggest dividing the spread by the stdev of SPX for the last 30 days to somewhat normalize the raw spread numbers. Once a relationship is identified and historically extreme levels are found you would then need to be able to create a position that gains value as the spread between the SPX and its 13 MA contracts.

    For example, the SPX has increased. The spread between the SPX and the MA becomes positive 60 and this happens to be above our positive threshold. A possible strategy would be to short the SPX and sell x number of put and y number of call contracts. You obviously don't know what the SPX will do going forward, but you do know what values are leaving the 13 day MA going forward. If you assume SPX stays unchanged you can calculate how much on average the MA will increase each day as the spread decreases.

    Theta(of the entire option postion)*(number of shares) should be equal to the average daily increase in the MA over x amount of days. Delta would be slightly positive, I think. Obviously you would have to play around with the strike prices, and take Gamma and Vega into consideration as well, but I think that this structure might work. The near month seems to be the best choice for big Theta's.

    So in summary, you would put the trade on when the upper or lower boundaries are penetrated and take the position off when the spread becomes near zero.

    I apologize for the long post, but I wanted to get some feed back on the overall structure. Does it sound feasible? Any thoughts or suggestions would be greatly appreciated.

  2. and how is that different from just averaging in and closing when the spread is maxed?
  3. jmsco


    I don't know if it is any different. Could you explain what you mean by averaging in and closing when the spread is maxed?

  4. jaan


    not really.

    what you effectively want to do is to buy the 13 day average whenever the price of the last day ends up higher than the MA. in order to do that you need to predict the last day's price 12 days in advance.

    - jaan
  5. well, if you go long on the close for 5 straight days, you own the 5 day ma. When price crosses the 5 ma, you wait for the spread to hit the maximum historical average high and you close out the trade for a nice profit.

    There are however a few minor details to this system that need to be worked out.
  6. jmsco


    Jann - Not really. You want to sell the SPX and buy a proxy for the MA whenever the spread has become historically large with the SPX greater than the MA. You don't need to know the SPX 12 days in advance. What seems to happen in the past is that either SPX pauses for several days or declines. In both cases the MA catches up to the SPX. In the case of the SPX pausing the time value gained from the options should approximate the gain in the MA. If the SPX declines the gain from shorting SPX should be greater than the loss from the options. However, you could still be right on the feasibility question.

    Profitseer - Your idea sound like the opposite strategy from what I proposed. You're looking for them to diverge. A problem I see with your idea is that the spread will often stay near zero with many small moves both positive and negative. First, how do you know which way the spread will expand. Positively or negatively. And what is the Max. What if the spread doesn't reach your MAX point before returning to zero and maybe beyond.?

    The reason I'm looking for convergence is that it seems that I'm better able to define it and I know what direction to expect the movement. It will always be towards a zero spread.

    Thanks for the replies,
  7. right, when you get the details worked out, it should be a money maker. You could use an ma crossover system. When the short ma crosses the long ma, expect the spread to widen in the direction of the short ma.

    If you want to trade convergence, just wait until your average price is way out of whack, then spread your average price against the current price, and wait for them to converge.

    Works best if the long side contains dividend paying stocks or bonds.
  8. jmsco


    Here's an example of trading the spread between SPX and its 13 day MA. This example is not based on any actual trades that took place. Its just an example using historical data for illustration purposes.

    Attached is a chart of the SPX. On October 15 the spread between SPX an the 13 day MA at the close expands to 61.23. The SPX is at 881.27. This is the first close above the upper bound for the spread. The upper bound is based on the historical relationship between SPX and the MA spread with a volatility adjustment. I expect the spread to contract within the next two weeks and want to create a position that capitalizes on this fact.

  9. jmsco


    I think the chart should be here, I hope.
    • spx.gif
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  10. jmsco


    I don't know what the SPX will do going forward. But I do know what the MA will do if SPX remains at 881.27 for the next 10 days based on the old data that is leaving the ma equation each day.
    In this case the 13 day MA will increase by $546.30 per thousand shares each day on average.

    Thus I want a position whose gain from the passage of time (Theta) is approximately equal to $546.30 and whose Delta is relatively small and positive. In this case I chose to write 7 Nov 850 put and 5 Nov 900 call contracts. The prices and greeks where acquired through a basic option package. The combined Theta creates a gain of $549.4 as each day passes and a Delta of $12.4. In addition I shorted 1,000 shares of SPY at 881.27.

    The attached chart illustrates how this position labeled Proxy tracts the actual spread between the SPX and the 13 day MA. The spread in this example converges in 12 days. There was also an opportunity to add to the position when the spread initially increased above the upper bound a second time.

    However I have a couple of concerns. What if Vega increase significantly? Also, this position, based on margin requirements for the SPY and options, was fairly capital intensive compared to the gain realized. Is there a better way with less capital to achieve the same result?

    Any ideas or suggestions would be greatly appreciated.

    #10     Nov 12, 2002