For traditional "buy and hold" investors that generally sit on their hands for most of the year, corrections in equity markets can be filled with angst and plenty of nail-biting.
When your risk profile is dominated by 50-50 directional bets, that's simply the Yin phase, when Yang decides to take a break.
While active traders can also feel pain during corrections, they generally view these periods as an opportunity, instead of a threat. And according to previous tastytrade research, this may be a productive mindset when an index like the Dow Jones Industrial Average (DIA) corrects by at least 5% in less than a month - as seen in May of 2019.
The DIA opened May of this year trading 266.47, but closed that same month trading down to 248.39 - representing a correction of roughly 6.8%. According to the aforementioned tastytrade research, it was after the DIA fell past the 5% correction point, that things really started getting interesting - particularly as it relates to selling premium.
A previous edition of the ever-popular Market Measures series took a closer look at the historical performance of selling puts in the Dow (DIA) after 5% corrections, and the results of that analysis are without question worth a closer look.
The study highlighted on the show hinges on historical data in DIA (from 2005 to 2018) which is divided into groups - all instances during that period, and then only the instances after which the DIA had dropped by at least 5% in a month.
The approach taken by the team was then to backtest a short put in DIA that was continuously deployed over the entire 2005 to 2018 timeframe.
The key aspect of this study was that it leveraged two different backtests in order to produce the data necessary for a side-by-side comparison. In that regard, the performance of “all instances” was compared to the group of data that included only the 5% corrections.
The graphic below summarizes the findings from both backtests, and provides critical insight into the respective performance of each approach:
(insert image 3 of 9 from May, 10 2018 Market Measures)
As you can see in the above chart, the performance metrics of the short put were boosted significantly when deploying this approach only after the DIA had dropped by at least 5%.
Notably, the overall success rate hardly budged, despite elevated levels of volatility in the markets when the DIA was correcting. On top of that, the P/L metrics improved considerably for the 5% correction group - pretty much across the board.
The data summarized in the chart above largely speaks for itself, but we hope you’ll take a closer look at the complete episode when your schedule allows.
The nice thing about this particular episode of Market Measures is that the analysis doesn’t end with DIA. The team also looked at two different single stocks (IBM and MMM) which had also recently experienced 5% corrections, and applied the same study parameters to each.
In those additional studies, the historical performance of the short puts in IBM and MMM were once again boosted when the strategy was deployed only after 5% corrections (as compared to "all instances”). The findings from each of the backtests conducted on IBM and MMM are presented in detail on the show.
It should be noted that trading options in single stocks such as IBM and MMM represents more risk than an ETF (like DIA) because of the idiosyncratic risk (i.e. stock specific risk) inherent in such an approach. Regardless, the studies conducted on IBM and MMM do at least help to reinforce the pattern observed in Dow Jones (DIA) relating to the historical performance of short puts deployed amidst corrections.
If you like this approach, and want to learn more, another previous installment of Market Measures expands upon this research by backtesting more underlyings - “Selling Puts in Beat Up Stocks.” This research is applicable not only during corrections, but also when “Blue Chips” are experiencing pullbacks in other types of markets (i.e. sideways or up).
Overall, the research presented on these two episodes is an important reminder that when stock indices sell off by 5% there is often a silver lining.
We look forward to hearing from you!
Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.
Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.