Overlay #2

The following is an explanation of tactical overlay #2


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                This second overlay will vary in its approach depending on the underlying strategy it’s looking to overlay. For example, let’s use the S&P 500 index as the underlying investment. The overlay looks at between 35-40 different sectors in the S&P 500 (sectors like retail, consumer services, energy, etc.). 


                The first question to answer is whether the majority of the sectors of the S&P 500 are up or down. If more than 50% are up that’s seen as a positive and if more than 50% are down, that’s seen as a negative. This provides a basic good or bad signal, but it needs to be refined.


                The refinement comes in the form of a percent (%) change filter that is overlaid on the local minimum and maximum daily data of the sectors.  This works like an oscillator (An oscillator is a technical analysis tool. A technical analyst bands an oscillator between two extreme values and then builds a trend indicator with the results. The analysts then use the trend indicator to discover short-term overbought or oversold conditions. When the value of the oscillator approaches the upper extreme value, analysts interpret that information to mean that the asset is overbought, and as it approaches the lower extreme, analysts consider the asset to be oversold).


                Short, mid-term, long-term signals—tactical overlay #2 has the ability to break its buy/sell signal out into three categories.


                Why is this interesting or important?


                Whereas tactical overlay #1 is primarily an all-in or all-out signal, tactical overlay #2 can be used by advisors who may want to only take a portion of a strategy to cash, AGG, or a short position.


                For example, when the short-term (data from 90 days or less) signal kicks in with a sell signal, an advisor may only move 20% of the underlying strategy to cash, AGG, or to a short position.


                If the mid-term (data from 90-120 days) signal kicks in, an advisor may move 50% of the underlying strategy to cash, AGG, or to a short position.


                If the long-term (data from 120-240 days) signal kicks in, an advisor would then move all of the money from the underlying strategy to cash, AGG, or to a short position.


                Tactical overlay #2 is not purely mathematical. Some tactical managers tout that they have no human thought in their models. It’s all algorithm based and no emotion. Tactical overlay #2 uses the signals as the primary indicator but there is still some amount of discretion afforded the manager making the final signal call.

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