Trading the SPY Pain Index

Trading the SPY Pain Index

What we are looking to identify is how much pain our positions and portfolio can handle in extreme events and each major pull back what the probabilities are of a rise in price in the underlying.

Data output is used by modifying and creating data points within the Zephyr Associates Pain Index.

Whilst there is some inherent problems associated with this, it will give the trader some idea of when to start adding to their positions, based on historical data and probabilities.

Below we will analyze the SPY historical data to come up with a trading strategy.

What we can see from the below chart is that at the time of writing the current draw-down is only 1.4% as we are near all-time highs again.

If we go through the data we can see that if we bought a contract at today’s price we have a risk of 55%-1.4% (current draw-down) = 53.6% based on historical data. Meaning if we bought at today’s prices of 210.62 for a contract value of $21,062 it will lose more than half its value.

Using the zephyr pain index we can see that mean draw-down sits at 11%. This means that the mean value of the draw-downs is 11% over the entire period and data set.

What we have done in this example is used the pain index as the entry level of the second contract, and the last contract in line with the max draw-down. To the right you can then see how the losses accumulate as well as the margin requirements for holding the positions. We can see that if over the next year the market steadily declined in value using this strategy of averaging down we would have needed $66,000 to keep the positions accumulated losses going and to cover margin. Whilst our break-even would be low and we would profit nicely in the years to come, its probably not the best strategy.

This starts a lot more questions; how can we make money from this information. Now let’s say we look at the pain index value of 11%. Why not leave this trade alone until the market has come back 11% then start trading. We all know that buying at the top of the market is bad business, so why not use the pain level as our first entry point. What would happen then is this would increase our probability of being correct and making money, right… Well let’s look at that more closely... If we sold puts at 11% and started trading that way, based on a 365 day draw-down period we can see from the chart below that we would have a 75% probability that the market would move upwards if it was trading at 11% discount to the all-time high.

Said differently if the market was trading at 11% discount and the trader was selling puts with a 70% probability of making money the probability of not getting exercised is about 93% based on the already built in discount of the market price. These are phenomenal numbers.

So let’s view this differently again. If the market is trading at the next level down of 26% from the all-time high, the probability of it rising is about 92%. Let alone adding in any short put premium and probabilities. 

This gets to the old saying of buying when their is blood in the streets. It would take a lot of guts to start buying at 26% draw-down as it is all doom and gloom, but the reality is a trader has 92% probability that the market will rise based on historical data points.

Every leg that the market pulls back is a greater probability that it will rise. The next thing missing in this formula and strategy is the time period it takes at each buy in point to for the SPY to rise and by how much. This will be covered at a later date.