The Safer Approach to Consistently Higher Returns
UZZ Fund uses a proprietary algorithmic approach to creating higher than average investor returns combined with a level of safety that may be surprising. Understanding how the UZZ Fund does this, and why it is different, requires us first to see how traditional approaches work.
Most funds rely on equity investment and trading, supplemented by appropriate options trades, to support their approach. A number of assumptions are made to enable this traditional approach:
1. Long term value creation is a matter of long periods of time invested in stocks and funds of better than average value and/or growth rates.
2. Appropriate allocation methods among sectors or types of funds reduces risk and allows for the best overall performance.
3. Short term trading cannot work in the long run because, the thinking goes, it requires predicting the large moves that are so important to long term performance (for example, only twenty days of a typical year account for nearly all gains for that year).
Ironically, it is because the UZZ Fund believes that markets are indeed unpredictable and that timing for equity gains is problematic that we believe our approach is superior. There is very little long term correlation between individual company performance and that company's stock performance. Most measures of such things asymptotically approach the long term S&P 500 average of 8% annual. This is the reason that index funds are so popular today. They deliver the average of the market and most managed funds deliver less.
We trade credit spreads because statistically they have a higher likelihood of success (66%) versus regular equity trades (33%) under short to medium term conditions. Credit Spreads rely on option premium - which we know declines to 0 over an options life - to create income in each period knowing the conditions that must be met to do so. We limit the number of vehicles we use because knowledge of behavior and risks counts more than knowledge of the market conditions or business environment (especially in an age of political spin and outrage). We limit our exposure both in terms of allocation of cash and in terms of time allocated to trades in order to gain when the getting is good and being in cash when it is not.
When Do We Trade?
In comparison to other funds, UZZ Fund has a very defined trading window and trading design. We only open positions between 3:30 and 4 PM on applicable Tuesdays. For a trade to be opened, it must meet all of a set of criteria including:
The first chart is of QQQ on 9/3 (at the far right the chart says it is 9/2 which is wrong) and what we want is for each of the three sections of the chart to line up in terms of BULLISH or BEARISH indication among them and within each section. Anything else - and it is no trade. There are a few reasons why QQQ was not traded on 9/3:
On 10/1 though, IWM showed a consistent BEARISH pattern as on this chart. All parts of each of the three sections are aligned to a BEARISH direction and thus all three sections agree. So we can look at IWM and if it has a trade of .05 or better with at least 80% OTM then the trade would be on.
What Do We Trade?
We trade weekly credit spread options in five popular exchange traded funds (ETF): QQQ, SPY, IWM, TLT, VXX. We have long experience with these ETF's both in swing trading as well as in option trades in general - but especially as credit spread trades. A credit spread is merely selling a higher priced option while also buying a lower priced option - the difference is the premium and that is how we make profits in the UZZ Fund. Typically, nine out ten such trades we do retain full value.
How Does Options Premium Work?
When we normally think about investing or trading stock funds, we tend to default to the notion that if those stocks rise in price, then we make money on them ("buy low, sell high"). An additional thought to this is that we can SHORT stocks and profit when prices on those stocks decline ("sell high, buy low"). Statistically, either of these approaches has a 33% chance of working over short (days) to medium (months) time frames. We'd like better odds than those!
In a credit spread trade, we use price direction and momentum as an indicator of possible trade success, but we do not rely on price movement for the profits we make. Instead, we capture option premium as the source of profits. When we do this, we have a 66% chance of success due to the nature of how option premium and price movement relate to each other. So what does that mean?
Let's use the IWM trade in the week of 10/1 above as an example. The trade pattern is BEARISH which means we expect the price of IWM to decline over time. The chart shows a confirmed BEARISH pattern for IWM so we have one of the three criteria for a trade to occur. The second and third criteria are interlinked - an 80% OTM trade at .05 or better. What does this mean?
80% OTM stands for 80% Out of the Money which is a real time statistical measure of an options likelihood of expiring out of the money. When we trade a credit spread, our goal is for that spread to expire out of the money and thus worthless. The higher the %OTM the more likely that will occur. Unfortunately, the value of the premium declines as %OTM increases. So while having a 95% OTM trade would be wonderful, the value of that would be extremely low.
So if the %OTM is 80% or better and we are trading a confirmed direction in line with that (either BULLISH or BEARISH) then we are setup for a high likelihood over 3 days to keep the premium we get. That is because we know under those circumstances that the premium will decline to zero at the end of the week (with weekly options). So what is the premium?
Premium is merely the difference between the higher price of an option we buy and the lower price of an option we sell (the "credit spread"). In the case of IWM on 10/1, the credit we can receive is $0.12 at 81.7% OTM using a CALL 151/152 spread (we are selling the end of week 151 CALL and buying an end of week 152 CALL). At the time of the trade IWM is trading at 148.4. As long as IWM stays below 151, we keep that $0.12 credit.
In our activity page, you'll see us indicate the exact trades we did that week. BEARISH trades will always be a CALL spread. BULLISH trades will always be PUT spreads. For example, in the same 10/1 week, we sold a TLT BULLISH PUT 141/140 for a $0.11 credit. This means we sold an end of week TLT PUT 141 option and we bought an end of week TLT PUT 140 option to receive the resulting $0.11 premium as a credit.
What About Allocations?
As noted below in "How Do We Protect Our Capital?", we use allocations for the Fund's total net asset value when doing trades. So how do those allocations translate into the trades we do? Let's assume our total net asset value is $100,000. We allocate 12.5% of net asset value to any trade we do (up to a maximum of four qualified trades per week). So this means that $12,500 would be the allocation for a trade. Using the examples above in the week of 10/1, IWM would return a premium of approximately $1500 ($12,500 * $0.12) and TLT would provide a premium of about $1375 ($12,500 * $0.11). The gain on those two trades for that week would be about 2.9%. $100,000 in starting capital would, at the end of the week, be $102,875 (note these figures are approximate as we are ignoring price variance due to timing and also trade costs in this).
How Do We Protect Our Capital?
In any trading system we need to protect our capital by insuring that no matter what happens or how sure we are of future events we can preserve the capital entrusted to us. We do this through the nature of credit spreads, capital allocations, and the use of stops on open spreads.
Credit spreads provide their trade benefit up front at trade open. Thus, we gain the capital necessary to close them if something should happen that alters their trading direction. It also helps that we only have trades open three days at the maximum of premium decline of these spreads.
At no time does the UZZ Fund allocate more than 50% of available capital to trades. In fact, we can only have four trades at maximum open (at 12.5% allocation each) and we usually have far less. In addition, we use time allocation in that we generally are in cash for at least 70% of the days of the year. All of these efforts are to be ultra safe and to focus on gains that can be realized only in the time frames that they are available.
The final measure of safety is the use of stops to protect open spread positions. If the market in any of these positions reverses to the extent that the trade no longer corresponds to the conditions in which it was opened, we close it. Generally, we usually make a small profit in any case but we can also have small losses in some cases. All of our capital preservation efforts result in safer fund operations with higher gains.
The UZZ Fund utilizes some unique approaches to insure higher returns with preservation of capital. For the full story of UZZ Fund operations, minimum investments, benefits and risks, please request a prospectus.
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