There is no single “correct” Regression Channel for a chart; however, unlike more subjective trend lines, there are some objective aspects to channel construction that can make it a useful tool for your trading. Last week I addressed basic channel construction and this week I look at two approaches to trading the channels. Both are rules-oriented, discretionary approaches with one more aggressive than the other.

There are a lot of different trade characteristics that can make it aggressive. In the approach described below, the time frame and security used are the two characteristics that qualify as aggressive. In terms of time frame, the movement of daily prices within a regression channel dictates buys/sells and as result, may generate frequent trades. You need to decide if this is suitable for your style. Consider extending the rules to weekly rather than daily movement.

The securities used for the aggressive approach include leveraged and short exchange traded funds [ETFs], along with long options on a well-correlated underlying ETF. First of all, if you don’ understand either of these types of securities, trading them is beyond aggressive, it’s irresponsible. If you have a decent understanding of equity ETFs such as SPY, the Standard & Poor’s Depository Receipt^TM [SPDR^®] which tracks the widely followed S&P 500^® Index, then you’re most of the way there on understanding leveraged and short ETFs.

ETF Risk Considerations

One fund family that offers very liquid leveraged, long and short ETFs for widely followed US equities is ProFunds. Table 1 identifies all of the ETFs used in the first trading approach:

* Check the prospectus for all risks associated with each ETF.

ETFs generally seek to track a specific index. In the not too distant future we may encounter many actively managed ETFs, but for now the universe primarily consists of more passively managed funds. While the ETFs do a good job of tracking the returns, there is not an exact match. Tracking errors seem to persist with all of these funds.

Unique risks for the leveraged (long and short) ETFs come from Swap Agreements which provide the leveraged and short returns for the security. A Swap frequently uses an index, fixed income product, or currency pair as a base for return calculations and a specific contract value (notional amount) to calculate returns. One party in such a variable Swap pays the returns and the other party receives it—the notional amount is not exchanged.

Since Swap Agreements are not standardized and do not clear through a central organization like stocks, options and futures, they have counter-party risk. So it’s possible that one party in the Swap Agreement does not receive the payment they are due if the other party in the agreement defaults.

Consider a basic example for a Swap Agreement:

• Notional amount of $1,000,000
• Returns based on S&P 500® Index (SPX)
• Monthly payments

From Jan 31, 2008 to February 29, 2008, SPX declined 3.48%. This means that one party in the agreement is obligated to pay the other $34,800. A fund that receives payments when the returns are negative will go up in value as the index goes down in value and the investment product used results in counterparty risk since the payments are not guaranteed by a third party.

Long, leveraged ETFs may hold the underlying securities in the index plus futures contracts and swap agreements while short ETFs appear to hold primarily swap agreements. Check the prospectus or fund family web site for the specific instruments held in a given ETF. The holdings are available daily as part of the transparency characteristic of ETFs. The prospectus will also include all types of risks associated with a specific ETF.

I consider short, leveraged ETFs aggressive instruments because of the counter-party risk associated with Swaps used. However, the risk is likely limited to the payments rather than the entire notional amount. That’s an educated guess since I don’t know the specific terms for the Swap Agreements used by the ETFs listed.

The only specific historic example I can go back to is the temporary halt in trading for SKF, the UltraShort ProFund ETF for the financial sector. In the fall of 2008, the ban on short selling the financials in the US stock market created issues for counterparties in the Swap Agreements within the ultra-short fund. This significant event resulted in a temporary halt to trading in SKF (hours) and the inability of the company to create new ETF units.

Since SKF did not cease to exist, experience a significant drop in value or other loss, I consider the counterparty risk in these instruments acceptable for me. I also consider the use of such instruments as speculative and aggressive since the Swap Agreements held with the ETFs are not transparent. You need to make the determination for yourself as to whether or not any of these products are appropriate trading vehicles for you.

An Aggressive Approach to Trading the Channels

This strategy uses SSO or SDS to establish long or short positions, respectively, based upon movement in SPY. It also uses SPY puts or calls to hedge the position. Ideally, the approach will flow in this manner:

1.  Identify a new trend in the and construct a regression channel,

2.  Monitor the channel,

3.  Establish long position in the ETF

• Enter a long position in the Ultra S&P 500 ETF (SSO) when the security successfully tests the lower channel line (bullish position) or
• Enter a long position in the Ultra-Short S&P 500 ETF (SDS) when the security successfully tests the upper channel line (bearish position)

4.  Create a partial hedge for the ETF

• When it approaches the middle regression line with momentum that is counter to position established or
• When it surpasses the middle regression line

5.  Sell the ETF if and when,

• SPY moves counter to the position established and breaks out of the channel before reaching the middle regression line (loss)
• It fails to surpass the opposite regression channel line (profit)

6.  Sell the option hedge if

• The ETF position is closed for a loss after SPY breaks out of its channel
• The ETF position is closed for a gain and SPY fails to move to the opposite regression channel line as the middle line serves as support/resistance for price.
• The strike price is out of the money [OTM] and there are 10 days or less to expiration*. SPY position within the channel will determine whether a new partial hedge is merited.

* Consider a longer-term hedge roll-out since time decay accelerates for OTM options with less than 30 days of expiration.

In the event 5b occurs, the opposite or reverse position can be established and the process repeated (i.e. go long SDS if SSO was just sold). While this trade approach has a basic structure, it is discretionary because momentum and volume are assessed as SPY approaches different regression channel lines. In addition, I use exponential moving averages [EMAs] to provide additional insight on trend moves and potential support/resistance. The discretionary style provides an example of the art and science required in many technical analysis approaches.

Figures 1 & 2 display a channel constructed using a start date of 8/24/07 and an end date of 1/18/08. The channel was monitored for approximately 6 weeks.

 

Figure 1: Linear Regression Channel for SPY (8/24/07 – 1/18/08)



Figure 2: Successful Test of Lower Channel Line

Figures 3 through 8 provide trade and hedge dates for one hedged SSO trade and one hedged SDS trade. Note that the black arrow displayed in the first figure on 1/18/08 remains visible throughout the remaining figures.

 

Figure 3: Enter Long Position in SSO (RSI Bullish Momentum)


 

Figure 4: Create Partial Hedge for SSO Position with SPY Puts (RSI Bearish Momentum)


 

Figure 5: Sell Long SSO Position & Enter Long SDS Position (RSI Bearish Momentum)

Figure 6: Sell SSO Hedge & Create SDS Hedge with SPY Calls (RSI Bullish Momentum)


 

Figure 7: Sell Long SDS Position (RSI Bullish Momentum)


 

Figure 8: Sell SDS Hedge (RSI Bearish Momentum)

Table 2 provides trade dates and details which assumes the closing value is used for a 100 share position and the next month or greater SPY options are used to create an approximate hedge of 50%.

The net gains excluding commissions were $254. A more aggressive approach would refrain from hedging the position (and sell in the event a channel breakout occurs in the opposite direction). The net gains for the more aggressive approach were $1,958.

SPY puts and calls are used for hedges since those options have much greater liquidity and narrower bid-ask spreads. The slippage costs related to wide spreads can be significant over time. Since the approach is not a delta neutral approach, it does not require a perfect hedge. When using leveraged ETFs, each 100 share lot represents twice the deltas. SSO is +200 deltas while SDS is -200 deltas.

Other Alternatives

As an alternate approach, consider using the non-leveraged ETF when trading in a direction that is counter to the regression channel trend (i.e. SPY in place of SSO when trading a downward trending channel or SH in place of SDS when trading an upward trending channel).

A second alternative is to structure the strategy as one that is delta neutral using just SPY and/or SPY puts & calls.

A Conservative Approach to Trading the Channels

This approach assumes the individual seeks to hold SPY as a longer-term investment and uses regression channels to hedge the position when it fails to surpass the upper channel line. The strategy uses SPY and SPY puts.

1.  Identify a new trend in the and construct a regression channel,

2.  Monitor the channel,

3.  Create a partial hedge for SPY

• When it approaches the middle regression line with bearish momentum and volume building
• When it approaches the upper regression line with bearish momentum and volume building

4.  Sell the option hedge if the ETF

• Position is closed
• When it approaches the middle regression line with bullish momentum and volume building
• When it approaches the lower regression line with bullish momentum and volume building

So really, the conservative approach uses regression channels to establish hedges.

For more information on Regression Channels, see Gilbert Raff, “Trading the Regression Channel” from Stocks & Commodities, V 9:10 (403-408).

To access other articles written by Clare White, please click here.

Clare White
Contributing Writer and Options Strategist
Optionetics.com ~ Your Options Education Site
Questions for Clare? Visit the Optionetics.com Discussion Board