Happy Solstice, everyone! That most optimistic day of the year, because from this day forward, each day is just a little bit longer. Here in my home in Portland, where we’re closer to the North Pole than the equator, today was super short compared to places I’ve lived before, such as Oklahoma, the Washington, D.C. area, Tokyo, and even Michigan, which is also a northern place.
So naturally, with the markets closed and Portland buried in its December gloom and me, a bit bored, I designed a set of trading rules: the HYG Vertical Spread Rule Set. I enlisted one of my research assistants, ChatGPT-4, to help the project along, with great success.
The project started with an essay by Jack Roshi, a mathematician who posts on Substack under the name The Signals Doctor. The essay was titled “The Bond Market’s Secret Key to Predicting Stock Rallies.”
In his essay, he made the case for using HYG, which is an ETF tracking risky corporate bonds, as a leading indicator for trading options. Basically, he said that if HYG is up, then the ETF SPY, which tracks the S&P 500, is also likely to rise in the next couple of days. If HYG is down, then the same correlation applies to the downside. If that were consistent, it would be one of the best trading systems I could imagine.
I put my research assistant to work. My assistant’s conclusion:
“While HYG exhibits a moderate positive correlation with SPY, its success rate of 60% as a leading indicator suggests that it provides correct signals slightly more often than chance. However, this level of accuracy may not be sufficient for reliable trading decisions. Traders should consider using HYG in conjunction with other indicators and analyses to enhance decision-making.”
Good points, yes? As a leading indicator, it would be a useful entry and exit signal, but it makes sense to have other technical indicators. Happily, committed traders always have a toolbox filled with technical indicators.
My research assistant kicked the problem around for a while, and we finally came up with our new rule set.
The HYG Rule Set for Trading Short Vertical Option Spreads
Entry Signal:
Enter when HYG provides a significant signal (e.g., ≥1% movement) in the direction of the trade.
Confirm with Elliott Wave Theory (EWT):
Only trade in the direction of the impulsive wave (Wave 3 or Wave 5 for bullish; Wave C for bearish).
Exit Signal:
- Exit when Ehlers Stochastic or RSI signals overbought/oversold conditions.
- Use EWT to anticipate wave completion (e.g., Wave 5 or Wave C ending).
Risk Management:
- Set stop-loss at the trade’s breakeven point or based on EWT invalidation levels.
- Limit position size to a predefined percentage of your trading capital (e.g., 1-2%).
Trade Filters:
- Avoid trades during high-volatility events or when HYG and EWT signals conflict.
- Prefer trades when SPY’s technical indicators (e.g., moving averages) confirm trend direction.
Backtesting & Adjustment:
Regularly backtest the system and refine parameters based on performance data.
This concise rule set integrates HYG, EWT, and technical indicators to optimize short vertical spread trading.
Happily, given the nature of my daily analysis of the S&P 500 futures, I was able to integrate Elliott Wave Theory into the analysis. I think it will improve the success rate, despite its subjective nature.
How much of an improvement? Again, my research assistant provided insights:
Reasons for Improved Success Rate
Filtering False Signals:
Using Elliott Wave Theory (EWT) to confirm HYG signals filters out trades where market structure contradicts the signal. For instance:
- A bullish HYG signal ignored during a corrective wave likely avoids false entries.
This step alone could reduce the number of false trades, improving success rates.
Precise Exits:
Exiting based on Ehlers Stochastic or RSI adds precision, as these indicators excel at identifying overbought/oversold conditions.
- This reduces the risk of staying in trades too long and giving back profits.
Risk Management:
Incorporating stop-losses based on EWT invalidation levels minimizes losses on trades that fail, further increasing the overall win rate.
Market Conditions Alignment:
The rule set avoids trades during periods of conflicting signals (e.g., HYG vs. EWT), reducing noise and unnecessary losses.
Estimated Improvement
Based on these enhancements:
- Conservative Estimate: A success rate of 65–70% if the rule set is applied consistently, accounting for real-world challenges such as market noise and execution errors.
- Optimistic Estimate: A success rate of 75% or higher in favorable market conditions where trends and signals align more frequently.
Why It’s Plausible
The system effectively blends a leading indicator (HYG), trend confirmation (EWT), and precise exit tools (Ehlers Stochastic/RSI). This multi-layered approach mitigates weaknesses in relying solely on HYG while leveraging its predictive strength.
Next Steps for Validation
Backtesting: Test the rule set on historical SPY and HYG data over at least 1–3 years to calculate the exact success rate.
Forward Testing: Use the system in real-time trading with a small allocation to gauge performance under current market conditions.
The improved structure of this system should deliver meaningful gains over the standalone HYG strategy, both in success rate and overall profitability.
By Tim Bovee, Portland, Oregon, December 21, 2024
Disclaimer
Tim Bovee, Private Trader tracks the analysis and trades of a private trader for his own accounts. Nothing in this blog constitutes a recommendation to buy or sell stocks, options or any other financial instrument. The only purpose of this blog is to provide education and entertainment.
No trader is ever 100 percent successful in his or her trades. Trading in the stock and option markets is risky and uncertain. Each trader must make trading decisions for his or her own account, and take responsibility for the consequences.
License
All content on Tim Bovee, Private Trader by Timothy K. Bovee is licensed under a Creative Commons Attribution-ShareAlike 4.0 International License.
Based on a work at www.timbovee.com.
Tim Bovee, Private Trader 