Tuesday, May 5, 2009

Sell in May and Buy Protection

Posted on Condor Options:

Investors should “sell in May and go away,” or so goes the old adage. We compared the returns for the Dow Jones Industrial Average since 1928 for the periods November-April and May-October to see how well this adage has held up in reality. Our findings are in the figure below.

Condor Options - Nov.-Apr. vs May-Oct.

Clearly, the November through April period has outperformed over the last 80 years - the difference in both the mean and median returns is enough to warrant further study. What also caught our attention is the difference in the average annualized monthly volatility, itself already a very smoothed measure. The most immediate practical implication is that a strategy that buys the Dow Jones Industrials during the months of November through April and sits in cash otherwise should have returns with lower volatility:


Returns above exclude transaction costs and returns on cash, and are logarithmically scaled. Higher risk-adjusted returns are very desirable, and one way to capture the lower return volatility of the “sell in May” approach while not giving up absolute returns might be to lever up during the November-April period and remain in cash or in a reduced portfolio otherwise. Just for kicks, we tested an approach that shorts the market during May through October (the “ShortInMay” line above); the Depression-era tumult really ruins that approach, as does missing out on the still-positive average returns of the maligned May-Oct period.

Conclusion: given the lower average historical returns and higher volatility of the May through October period, large-cap stock investors may want err on the side of buying more portfolio protection in the form of index puts during that time.

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