Market timing on the Johannesburg Stock Exchange using derivative instruments

This paper investigates to what extent superior returns can be obtained from a market timing investment strategy on the Johannesburg Stock Exchange that makes use of derivative instruments. Traditional timing approaches, where timed switches are made between risky equities and risk-free cash, suffer from various liquidity and cost constraints. Timing using options is proposed as a more practical and efficient alternative. Two timing strategies are considered: bear timing, where put options are purchased in an attempt to protect an equity portfolio from market downturns, and bull timing where call options are purchased to enable a pure cash investor to participate in market upturns. Fair Value Models and Black-Scholes Option Pricing Models are used to price put and call options on the All Share Index and All Share Index Future for the period 1963-1992. Computer simulations are used to simulate the timing decision-making processes of investors with varying abilities in forecasting market movements. The research shows that extraordinary rewards are achievable from timing strategies using options. However, superior accuracy in forecasting market movements is still a critical factor in determining success. Bear timing is preferable to bull timing in efficient and rational markets. Nonetheless, in markets where deviations from the fair value of futures contracts occur, bull timing provides large arbitrage opportunities. A bear timing strategy with a short review period would appear to offer an attractive risk/return trade-off. (C) 1997 Elsevier Science Ltd.