Category: Investing Insight

Investing insight to make you a better investor.

Implied Volatility around Earnings Announcements

Introduction

There is a common belief that option implied volatility, which is high before earnings announcements, quickly dissipates after the event. So sell options before the event to profit from the fall in IV. We decided to put this theory to test by observing at-the-money IVs 5-days before earnings announcements and their subsequent behavior.

It is not what you expect.

ATM IVs

Here are the at-the-money implied vols 5-days before and the day after announcements:

atm iv announcement

In our study, IV falls only 44% of the time. So the blanket statement fails. IV dissipation is not guaranteed. There are a lot of other things that affect IV and earnings alone is not sufficient to predict the outcome.

However, if the IV was more the 50, then IV dissipates 70% of the time. However, these odds could be similar to those without earnings announcements as well (all things equal.) So further research is required.

Conclusion

Don’t go around selling options thinking that IV will dissipate after earnings announcements. Know your odds.

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Stop-loss and Re-entry

Introduction

A trailing stop is a percentage below the most recent high at which you exit a trade. It allows you to lock-in gains while avoiding catastrophic loss. There are lot of opinions about where these should be set. And more importantly, when to re-enter. What follows is a discussion on how different stops and re-entry rules affect trading frequency and returns.

We will consider time-series from 2010 through now on the NIFTY, BANK NIFTY and CNX MIDCAP indices. During this time, the cumulative buy-and-hold returns were 61.47%, 104.81% and 75.61% respectively.

A simple 5-3 Rule

“A good plan violently executed now is better than a perfect plan executed next week.”
– George S. Patton

To get us started, we propose a trailing-stop loss at 5% and a re-entry rule that triggers when the index covers 3% from the lowest level since exiting the trade. This rule significantly increases returns and reduces draw-downs across all indices.

nifty.stop-loss.2010.5.3

bank-nifty.stop-loss.2010.5.3

mid-cap.stop-loss.2010.5.3

Index #trades cum. returns
Nifty 139 366%
Bank Nifty 209 2291%
Midcap 159 382%
The boost in returns come at additional trading costs. And even though the average number of trades work out to less than one a week, there maybe periods where it might trigger every day.

The 5-3 Trading frequency

Let’s plot the days on which this rule triggers (both buys and sells.)

nifty.stop-loss.trades

bank-nifty.stop-loss.trades

mid-cap.stop-loss.trades

By the looks of it, the stop-loss and re-entry bands are too narrow.

The 10-5 Rule

Suppose we set the trailing-stop loss at 10% and re-enter when the index covers 5%, we end up with a strategy with lower number of trades and yet, better returns and buy-and-hold.

Index #trades cum. returns
Nifty 50 100%
Bank Nifty 103 536%
Midcap 66 162%
Lower trading but lower returns as well.

Returns:
nifty.stop-loss.2010.10.5

bank-nifty.stop-loss.2010.10.5

mid-cap.stop-loss.2010.10.5

Trading Events:

nifty.stop-loss.trades.10-5

bank-nifty.stop-loss.trades.10-5

cnx-midcap.stop-loss.trades.10-5

Trailing stop-loss and re-entry scenarios

The master list of different strategies, their trading frequencies and cumulative returns.

trailing stop-loss and re-entry scenarios

Conclusion

Having a trailing stop-loss and re-entry strategy enhances returns but at the price of increased trading frequency. No combination of strategies can escape the doldrums – where the index is basically flat and you are getting whipsawed.

With a 15% tax on short-term gains, over the 5-year period, you should handicap strategy returns by 75% to do an apples-to-apples comparison on the tax-free buy-and-hold returns. If you use the 10-5 rule, it means you will only come-out ahead trading the Bank Nifty. So you are better off with the 5-3 rule given where trading costs stand.

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Investing in European Equities

Why Now?

Here are the top 5 reasons why investors should look at European equities:

  1. The ECB’s $1.1 trillion bond-buying program is beginning to kick in.
  2. The slide in the euro’s value against the dollar has also made European exports more competitive.
  3. Valuations appear attractive.
  4. Eurozone corporates are less leveraged, and their profitability has remained resilient.
  5. Greece is a source of uncertainty. Investing during uncertain times bears outsized returns.

How?

Unless you have a foreign equities trading account, the only way you can invest in European equities are through feeder funds or international funds. Feeder funds are just a wrapper around another fund. One such fund is the Religare Invesco Pan European Equity Fund. It feeds into the Invesco Pan European Equity Fund (MorningStar.)

It can be argued that investing in a narrow geographic is riskier compared to investing in a broad international fund. We had highlighted one such fund, the Birla Sun Life International Equity Fund Plan A, in our post about investing in non-rupee assets. If you compare the two, between 2014-03-03 and 2015-06-25, Religare’s fund gave an IRR of 1.27% vs. Birla’s 7.14%download Although this blows when compared to the CNX Midcap (IRR of 48.41% in the same period), remember that investing is all about prospective returns.

Risks

There is always the risk that Greece will blowup and drag Italy down with it, causing the Eurozone to implode. Tack on the risk of active management and currency risk (the rupee might appreciate against the euro), it becomes a pretty scary proposition. But remember, investing during uncertain times bears outsized returns.

Call us to discuss whether this fund is right for you.

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Momentum should be part of every portfolio

The Two Anomalies in Finance

Momentum and Value remain the two “anomalies” in finance. The Efficient Market Hypothesis cannot explain why value investing, where investors pick up “under-priced” stocks, and momentum investing, where investors bet on stocks that have already run up, give out-sized returns compared to the rest of the market. After all, aren’t markets supposed to discover the “right” price and negate these effects?

Investing in Momentum

Value investors get a lot of face-time in media – people like to hear about stocks that are “hidden gems” that can suddenly come alive and give out-sized returns. However, very little is spoken about momentum investing. This results in investment portfolios that are underweight momentum.

The problem with momentum investing are the large draw-downs. When momentum stocks tank, they do so spectacularly. The draw-down keeps away most mutual funds from seriously pursuing this strategy: a) they can’t get out easily, and b) if they show too much volatility, investors will revolt.

But individual investors don’t have these constraints if they learn to embrace volatility.

Comparing Momentum Returns

Our FundCompare tool allows you to see how momentum investing has fared over different time-frames and compare their returns to whatever mutual fund you own. For example, if you compare Momentum with the ICICI Value Discovery Fund, here’s how the monthly returns compare:

Between 2014-01-01 and 2015-06-18, Momentum has had an IRR of 70.16% vs. ICICI Prudential Value Discovery Fund’s IRR of 50.05%download

How much should you invest?

Risk, at the end of the day, is whatever allows you to sleep at night. You could start with a 10% allocation and scale till you reach your limit. Whichever way you choose to go bout it, our Momentum Theme will be ready for you.

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Mutual Fund Performance Chasing

Introduction

Mutual fund sales brochures and distributors often highlight past performance. Why? Because performance sells. The disclaimer that “past performance is not an indicator of future returns” is buried in small-print at the back of the book.

To see how bad a predictor past performance is of future returns, we came up with a novel idea. We used the Relative Strength Spread that we wrote about recently and applied it to mutual fund returns. This gave us three things:

  1. Normalized returns with respect to CNX 500 irrespective of the fund’s benchmark.
  2. A visualization of the performance gap between the best and the worst funds. And,
  3. A parade of top-10 and bottom-10 funds across different periods of time.

Relative Performance

Here’s how the spread between the top and bottom-decile looks like with a 100-day lookback:
CNX 500.mf.relative-spread-index.100

And with a 365-day lookback:
CNX 500.mf.relative-spread-index.365

When the broad markets go up, the performance gap between the best and the worst funds widen. Some managers wring more out the markets than the others. However, during the bear phase, the relative performance between different funds compress. If the market is bad, they all look beige.

Longevity of returns

Is the out-performance sustainable? If you picked the best performing fund this year, will it retain its position the next? Click to embiggen:

mutual fund relative performance decile

None of the top performers in 2010 retained their spot in 2011; same as in 2013 vs. 2014. There were a few cases where funds in the top-decile slipped to the bottom decile the next year. It is a total crap-shoot.

Conclusion

There is absolutely no connection between past performance and future returns. If fund managers require a broad-based rally in the markets to out-perform, then they are in effect, chasing momentum.

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