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Exploit U.S. Stock Market Dips with Margin?

| | Posted in: Equity Premium, Strategic Allocation, Volatility Effects

A subscriber requested evaluation of a strategy that seeks to exploit U.S stock market reversion after dips by temporarily applying margin. Specifically, the strategy:

  • At all times holds the U.S. stock market.
  • When the stock market closes down more than 7% from its high over the past year, augments stock market holdings by applying 50% margin.
  • Closes each margin position after two months.

To investigate, we assume:

  • The S&P 500 Index represents the U.S. stock market for calculating drawdown over the past year (252 trading days).
  • SPDR S&P 500 (SPY) represents the market from a portfolio perspective.
  • We start a margin augmentation at the same daily close as the drawdown signal by slightly anticipating the drawdown at the close.
  • 50% margin is set at the opening of each augmentation and there is no rebalancing to maintain 50% margin during the two months (42 trading days) it is open.
  • If S&P 500 Index drawdown over the past year is still greater than 7% after ending a margin augmentation, we start a new margin augmentation at the next close.
  • Baseline margin interest is U.S. Treasury bill (T-bill) yield plus 1%, debited daily.
  • Baseline one-way trading frictions for starting and ending margin augmentations are 0.1% of margin account value.
  • There are no tax implications of trading.

We use buying and holding SPY without margin augmentation as a benchmark. Using daily levels of the S&P 500 Index, daily dividend-adjusted SPY prices and daily T-bill yields from the end of January 1993 (limited by SPY) through May 2020, we find that:

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