options on results of stock screeners

Discussion in 'Options' started by tedthedog, Sep 3, 2011.

  1. tedthedog

    tedthedog

    I'm new to options and am interested in using them to goose performance and hedge risk, in combination with stock screeners that try to choose equities with a given direction, e.g. bullish. Three ideas are given below, feedback would be welcome. The stock screener I'm most familiar with is by Joel Greenblatt, who seems to be a reputable academic as well as an investor with street creds. His "Magic Formula Investing" stock screen (horrible name), when back-tested, performs very well in identifying value stocks that give excellent returns on average compared to the S&P on an annual basis. He web-publishes a free, ranked list of stocks. Interestingly, the better ranked stocks in this list performs very well as "value" stocks (in back tests), while the worst ranked stocks perform poorly. He recommends choosing from among the large number of best ranked stocks to form a small portfolio of about 30 stocks, hold them for a year, and then sell. He recently formed some mutual funds that implement his stock picking strategy.

    My goals are (a) market beating returns when averaged over a few years (somewhat less than Greenblatt's but more than the market is fine), (b) black swan protection, (c) not investing large amounts of time and effort. Feedback on the following three thoughts would be most appreciated!

    (1) The simplest idea is to just buy Greenblatt's mutual fund and also buy protective puts on say SPY (or another ETF?) to address black swan concerns. Due to the put purchase the return on this package will be lower than on his fund alone (in non-BlackSwan years) but conceivably could still handily beat the market. Buying simple puts for Black Swan protection over the span of a year on a long position is often too expensive, the idea here is that the claimed returns on his stock picks make the package of fund+puts a vehicle for high return but with downside protection. This plan in principle achieves two of my goals (market beating with downside protection, and is simple to implement), but doesn't goose performance by using options, and it also ties up money in stocks that he recommends only holding for one year.
    (2) Because Greenblatt lists his ranked stocks on his free website one could instead buy DITM calls on a choice of 30 of the best ranked stocks, instead of buying the individual stocks (or his fund). This takes less money than buying stocks and the DITM calls should have high delta and act similarly to stocks. Or, I suppose one could simply buy OTM calls (but at what strike?). Either way, one could also buy protective puts on some index ETF as in idea (1), or alternatively buy protective puts on the 30 individual stocks themselves, and in principle achieve market beating return on the whole package while having Black Swan protection. Viewed as a package, some of the upside of the "magic formula" is traded for protection when buying the puts, but one gains leverage by buying the calls instead of buying stock. The options need to span a year, so one possibility is to use LEAPs, but one might worry that sub-selecting from his list of better ranked stocks for those with LEAPS might screw up the claimed performance. If this is a worry, then presumably one could instead do a series of normal options to cover the one year span he advocates owning the stocks.
    3) Ideas 1 and 2 don't goose performance. To try and do so using an options strategy, note that he ranks a large number of stocks and claims that back-testing shows that poorly ranked stocks perform poorly while the better ranked stocks beat the S&P (by a lot, on average). He mentions in his 2010 book that the idea of trying to goose performance by longing the top ranked stocks and shorting the bottom ranked stocks had been tried, but that in back-tests this strategy went bust. I assume that he actually shorted the stock, but wouldn't it be less risky to simply buy puts on a selection of the worst-ranked stocks? (Note that these puts are much different than the protective puts in ideas (1) and (2) above, those puts were either on an index or else protective puts on the better ranked stocks). Then instead of going long on stock, instead buy either DITM or OTM calls as per idea (2) on a selection of the best-ranked. If so, shouldn't this be a less risky alternative to the "long the top and short the bottom" strategy to goose performance? A disadvantage of ideas (2) and (3) is that they are a more active and time-consuming strategy than idea (1).
     
  2. rmorse

    rmorse ET Sponsor

    I believe unless your goal is to actively scalp or volatility trade options, you should not look at the options first. Decide on a trading strategy for the security first. You want to be long, short or believe nothing will happen over a period of time with that security. Then, look at the options and decide the best way to accomplish your strategy with or without the base equity/etf.

    Randomly choosing an option strategy for every event will likely give you bad results.
     
  3. tedthedog

    tedthedog

    you should not look at the options first. Decide on a trading strategy for the security first. You want to be long, short or believe nothing will happen over a period of time with that security
    I'm sorry, I think I wasn't being clear: I'm bullish on the securities that the stock screener lists as best ranked. These are good "value" stocks that will on average tend to rise over the course of a year assuming that the back-tests of the screener portend future performance. On the other hand, those stocks ranked worst by the screener tend to perform poorly and I'm bearish to neutral on those. The simplest strategy that uses this ranked list of stocks in order to gain value would simply do what the originator of the screener suggests: buy a portfolio of the best ranked stocks, hold for one year, and sell; this works well in back-tests. The three different options strategies I presented try to capitalize on this ranked list of stocks that would one hold for only one year, by using options strategies (possibly LEAPS) in different ways:
    - (1) Buy the best ranked stocks, but also provide Black Swan protection by buying a protective put on an index that would tank in a Black Swan event similar to how the stocks would tank. Typically, buying Black Swan protective puts for stocks on which you're long for a year is too expensive. But the expected average annual returns on these stocks are projected to be so high that I'm prepared to give up some of that high return in buying protection, the total stock+put return should still be high.
    - (2) Avoid buying the best ranked stocks and tying up capital, instead buy DITM calls (high delta, should track the underlying stock). Similar to (1) above, buy protective puts on a index that would tank in a Black Swan similarly to your stocks. Or else buy individual protective puts for the stocks for which you the bought DITM calls. Here, one substitutes buying DITM calls for being long on the stocks, and because the expected return over a year is so high one also buys some Black Swan protection via puts and still expects a high return.
    - (3) This approach is different, it uses both the best ranked and the worst ranked stocks whereas ideas (1) and (2) above involve just the best ranked stocks. The high ranked stocks are expected to go up significantly on average over a year: buy calls on them. The low ranked stocks are expected to do poorly: buy puts, or a more neutral strategy.
     
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  5. tedthedog

    tedthedog

    Thank you very much for the replies.
    rmorse:
    I apologize for having been unclear, I was in fact looking at stocks first. These stocks are the output of a stock screen that ranks stocks: "value stocks" that are expected to rise significantly over one year are towards one end of the ranked list. I was interested in exploring how one could use stock options in lieu of buying these value stocks, holding them for one year, then selling (which is the suggested protocol for how to use the results of the stock screen).
    spindr0:
    (1) You're probably right about chasing unicorns. I'm just exploring ideas as I learn about options, and for purposes of argument I'm assuming that the stock screener would work as well prospectively as it did in back-tests. If so, the idea is to buy some protection (puts) and still be able to beat the market due to the average upward movement of the selected stocks.
    (2) It is indeed a tall order to pick stocks that move up nicely. I'm assuming for purpose of argument that the stock screen will perform as well in future as it did in back-tests. It may not.
    (3) Regarding shorting the bottom of the ranked stock list and going long at the top, I agree that it's disturbing that back-tests showed this strategy went bust. However, actually shorting the stock is riskier then just buying puts, so I thought there might be some hope left in buying long calls on the best ranked value stocks and buying puts on the worst ranked dogs.
    (4) Regarding your favorite comment of mine: in my role as newbie I'm pleased to be able to bring a smile to the face of sophisticated investors. More seriously, I am investing significant time and effort in reading options books etc., I just meant that I don't see myself becoming someone who spends the major part of their day in trading. I have a background in analysis of scientific data of various types and I am very grateful for the feedback as I start to consider financial data and analysis.
     
  6. rmorse

    rmorse ET Sponsor

     
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  8. tedthedog

    tedthedog

    rmorse and spindr0:
    Thanks for the suggestions, I will look into them.