Dear StreetAuthority readers,

Next week, I’m headed to the 2015 Market Technicians Association’s (MTA) Gala Awards Dinner in New York City. The event is hosted by the MTA, a global organization of 4,500 professional investment analysts.

I’m going because Amber was awarded the 2015 Charles H. Dow Award. This award was established in 1994 by the MTA to highlight outstanding research in technical analysis. This is an incredible achievement and recognition of Amber’s expertise in the field.

As StreetAuthority readers, you’ve likely heard of Amber Hestla or maybe even profited from her research. Her award-winning paper detailed and tested the strategies she uses to select trades in her premium newsletter, Income Trader. She’s closed 86 straight winners selling put options, but the results of her research can be applied to other trading strategies.

So in today’s issue, we’re doing something a little different. Amber will be revealing the results of her research. I hope you find this information — which is not available anywhere else — as extraordinary as I have. 

Congratulations, Amber!

Frank Bermea 
Publisher, Profitable Trading

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I spend a great deal of time studying and building on the works of successful investors. One of the most influential on my investing career has been Larry Williams, a well-known trader and author of the 2003 book, “The Right Stock at the Right Time.” But it was actually an article he wrote in 2007 that has been one of the keys to my success.

Many traders follow the Volatility S&P 500 Index (VIX) because they expect it to help them spot changes in the direction of price trends. VIX is helpful in finding turning points in the S&P 500 index because futures on that index are used to calculate VIX. In general, traders look for high VIX levels as a sign of a market bottom and low levels as a sign of a potential top.

But while VIX provides information about the broader market, it doesn’t say much about specific stocks.

That all changed in 2007, when Williams published an article in Active Trader called “The VIX Fix.” This article detailed an indicator that mirrored the VIX but could be calculated for any stock, ETF or security that’s traded. It was presented as a way to obtain the benefits of the VIX for individual securities.

#-ad_banner-#I immediately realized that this idea was incredibly valuable and began researching it in detail. I eventually had two important insights into this indicator.

The first was that, while the indicator was appealing, it didn’t give timing signals. Like the VIX, peaks and troughs in the indicator were visible only in hindsight. 

Second, Williams’ new metric was a measure of volatility. When the indicator was high, volatility was high, which is the ideal time to sell options. Unfortunately, this is also among the riskiest times to sell options because we have no way of knowing when volatility has peaked. With the right tweaks, I thought, we should be able to apply Williams’ VIX Fix to options selling.

To solve these problems, I added a moving average (MA) to the indicator. MAs are widely used in technical analysis to generate trading signals and are commonly applied to prices and to indicators. Popular indicators like stochastics and moving average convergence/divergence (MACD) are based on MA crossovers, so I knew this was theoretically sound. With extensive testing, I quickly found that it was a profitable insight.

By adding an MA to the VIX Fix, the market action would tell me when volatility had reached a short-term peak, allowing me to balance the potential risks and rewards of options selling.

With these insights, I created my own metric: the Income Trader Volatility (ITV) indicator.

Looking at the logic and results of ITV, I felt confident that I had created something good. But I wanted feedback from other professionals in my field, so I submitted my research to the Market Technicians Association.

In my paper, “Fixing the VIX: An Indicator to Beat Fear,” I explain the value and the limitations of the VIX before introducing the VIX Fix and detailing the way I use this indicator. There are a number of test results in the paper, including results using 15 years of data for the components of various indices, which are shown below.

Before I talk about the results and what they mean, I’d like to explain the table. The test results shown here focus only on my ITV indicator strategy and do not include other filters I apply when recommending trades to my subscribers.

I tested this strategy on each of the individual stocks in multiple indices. While the results varied some, they all had an average annual return of more than 10%, twice the average annual return of a buy-and-hold strategy (shown as the last row in the table). 

The third column in the table shows the percentage of trades that were winners. This is consistently between 40% and 45% in my testing, which might seem low, but is actually standard for a trend-following trading strategy designed to catch big winners and take losses quickly. 

Maximum drawdown, the fourth column, is my favorite way to measure risk. This is the largest amount of money you’d have lost in your account over the test period. In my testing, I found that buy-and-hold investors would have suffered a maximum drawdown of 55% during the past 15 years. This means a $100,000 account would have fallen to $45,000. It eventually recovered, but if you needed access to your money when the market was falling, you would have been out of luck. 

On the other hand, when I applied my ITV strategy to the stocks in the S&P 500, it lost a maximum of just 28% over the same time period. This is a large loss, but it’s half as much as a buy-and-hold strategy. When the tests show that the largest loss is less than buy and hold, I consider the strategy to be less risky. As the table shows, this strategy can be higher risk when applied to high-volatility stocks like the components of the Nasdaq 100.

The last thing I tested was the amount of time the strategy would be invested. Professionals look at this number because it helps them understand whether a strategy can be combined with others. In this case, when applied to the stocks in the S&P 500, the strategy was invested just 27% of the time. 

My takeaway is that I could use the money for other strategies 73% of the time and further improve on the annualized returns. This might not be an important measure for individual investors, but market pros frequently use several strategies at once to maximize their gains.

The tests show that the VIX Fix with a moving average — the ITV indicator — can provide market-beating results with less risk than the overall market. While these results are good, the win rates are low and the risks can be high. Risks are especially important to consider when selling options, so I apply other indicators when I search for the ideal trade. 

Note from the publisher: As I mentioned earlier, Amber has closed 86 straight winners in Income Trader thanks in part to the ITV indicator. In her newsletter, she focuses mostly on selling puts, a strategy many investors overlook or don’t understand. If you fall in that camp, I can’t urge you enough to check out this eight-minute video about selling options. It will tell you everything you need to get started.

If you are familiar with selling options and want Amber’s trades sent directly to your inbox, you can sign up for her newsletter here.

This article was originally published on ProfitableTrading.com: The Award-Winning Strategy That Led to 86 Straight Wins