The Timing Program

Kaufman320-257.timing

This program includes:

  • An arbitrage between equities and the three major index ETFs, SPY, QQQ, and IWM.
  • An ETF program that uses the timing signals to buy undervalued sectors, a form of sector rotation.

There are multiple portfolios to help  fit your investment needs.

 

Timing (with its own Sector Rotation) is a strategy based on pairs trading logic, also called relative value arbitrage, as written in Alpha Trading (by Perry Kaufman, Wiley, 2010). Opportunities in pairs are based on identifying when two related stocks are moving apart, then entering at extreme divergence and exiting when they return to "normal." This is done using the Stress Indicator. It is a high-probability strategy because similar stocks, such as airlines, home builders, or health care providers, all share common customers who respond to the same economic conditions. Typically one stock moves first and the others catch up soon after.

This strategy can also be applied to sector ETFs, which can be compared to the major market index, the S&P, or to QQQ or IWM, whichever is appropriate. Those ETFs that lag the index have a tendency to catch up. If we look as a small set of SPDR ETFs, we can create a strategy similar to sector rotation. More information on this can be found at the end of this section.

Unique Features of the Timing Program

There are a number of issues that make pairs trading difficult for most investors.

  • The large number of stocks that have to be scanned looking for opportunities.
  • The need to sell short one stock against another. Short sales may not be possible in every stock. They require “borrowing” the stock and paying the dividend as well as interest on the cost of the stock, reducing the potential gain. Some stocks don't have shares available for borrowing.
  • The arbitrage between two similar stocks yields frequent but often very small profits.

To avoid these issues and make the strategy more profitable, our Timing program:

  1. Only buys the undervalued stock when a pairs signal occurs. It does not sell any stock short.
  2. Measures all stock signals against the SPY, QQQ, or IWM, rather than another stock, which opens up a much broader set of opportunities. The choice of index is based on performance, because it is often too difficult to decide to which group a stock belongs.
  3. Hedges a percentage of the risk of all positions when the trend of the S&P is down. This trend is assessed over multiple time periods, and entered in phases, to make the process smoother.
  4. May hedge by shorting the SPY or buying SDS (the inverted, double-leveraged SPY) for trading in accounts with short-sale restrictions. The double-leveraged inverse for QQQ is QID and for IWM it is TWM.

This program also uses a stop-loss of 15% from the initial entry. While stops are notorious for getting you out at the worst time, this program will hold a trade until it returns to normal, and only hedge if the trend of the index is down. If we had bought Enron and watched it plummet while the overall market remained in an uptrend, we would have no way to exit. Therefore, a stop-loss is a necessary evil. It is also not a guarantee of the exact price at which you can exit the trade.

Dynamic Portfolios

From a selection of about 220 stocks (this will vary) we dynamically select 10 or more stocks based on performance, volatility, and activity,  avoiding those stocks that do not track the broad market index, either the SPY, QQQ, or IWM. When a stock is selected, the position size is based on an investment of $10,000 divided by the current price. While this isn't a perfect method, it goes a long way towards equalizing the risk of each trade. We use $10,000 to make it convenient to scale up or down to your own investment size.

These portfolios have historically outperformed the market in terms of risk and return, avoiding the major drawdowns in 2002 and 2008 . You will see in table and chart below that the smaller portfolio has high returns but also higher risk.*

G3 Timing Returrn summary

For updated performance, go to the home page and click on the Performance tab along the top.

G3 Timing NAVs

Selection Criteria

Stock selection is based on three criteria,

  1. The stock must have a trading signal,
  2. It must have higher volatility than the average stock, and
  3. It must have a history of being profitable.

By eliminating those stocks that have low volatility, and therefore low returns, we greatly increase our expectation of higher returns. Because these trades typically last for only 5 to 8 days, and must satisfy strict entry criteria, there may not always be enough trades to fill the portfolio. On average, a portfolio will be filled to about 65% of its capacity. Then an account size of $50,000 will, on average, hold positions worth $32,500.  Then the returns shown in the table above are based on lower exposure, therefore, lower risk.  Simulated trades go back to April, 1999 where possible.

For a current view of portfolio returns, go to the Performance page

All things being equal, as the size of the portfolio increases, the returns (AROR) decrease but the ratio increases, showing that more stocks generate smoother returns. As the size of the portfolio gets larger, the percentage of stocks that can fill that portfolio will decline, causing returns to be lower, but more stable You can leverage your returns by choosing a larger portfolio, say 30 stocks, but then taking only the first 15 that give trading signals. In that way you will have more stocks in your portfolio most of the time. While this sidesteps some of the dynamic features of the portfolio process, it should increase returns.

You can reduce the portfolio size by allocating $5,000 per stock, or less, but then commission costs will have a greater impact on your returns. We have used a charge of $8 per trade, but a lower fee will significantly improve the returns. We have found that it’s best to commit at least $7,500 to each stock.

Placing Orders

Signals for all stocks and selected ETFs are provided daily, based on the previous close, as are signals for each portfolio. Orders are expected to be executed on the following open, and we strongly recommend using limit orders. The opening range for any stock can be quite wide. Without using limit orders you will often get a disappointing price. You will also note that opening prices for most data providers may be different. Some use the average of the first minute of trading, and others use the first trade. Our performance record will vary from yours on specific trades, either better or worse, but should even out over time.

ETFs and Sector Rotation

Many ETFs are actively traded but not all of them make sense arbitraging against the SPY or any other index. You might argue that gold moves opposite to the SPY, but bonds can go either way. What does make sense is arbitraging the sector ETFs against SPY.  By buying those sectors that are discounted to SPY we create a portfolio of sector rotation. If the broad market turns down, we sell the SPY against the risk of the open positions; otherwise, we only take long positions in the sectors and exit when they are no longer oversold. This program dynamically selects up to 8 of 16 sector SPDRs, with an assumed investment of $10,000 in each trade.

Sectors included in this portfolio are Gold Miners (GDX), Materials (XLB), Metals & Mining (XME), Consumer Discretionary (XLY), Retail (XRT), Staples (XLP), Energy (XLE), Oil & Gas Exploration (XOP), Oil & Gas Equipment (XES), Financials (XLF), Preferred Stock (PFF), Health Care (XLV), Industrials (XLI), Reit (VNQ), Technology (XLK), and Utilities (XLU).

Historic results can be seen in the table above. For the current portfolio and performance, see the Performance tab on the home page.

*NOTE: Neither actual or simulated performance may be indicative of future results.   

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