Option Strategist Option Based Portfolio Management Equity Derivatives Solutions – S&P 500 Index October 2012
Q M S Advisors .
This material does not constitute investment advice and should not be viewed as a current or past recommendation or a solicitation of an offer to buy or sell any securities or to adopt any investment strategy.
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Option Based Portfolio Management Tail-risk Hedging and Income in a Multimodal World GOAL
Enhancing Long-Term Portfolio Performance while Mitigating Equity Drawdown Risks Equity markets are likely to keep on experiencing periodic, broad-based and dramatic selloffs going forward. Adopting an Options Based Portfolio Management approach to investing (OBPM) in the chaotic, multi-modal market environment we entered since 2008 is particularly pertinent.
Risk can be an abstract concept until it materializes. In 2008 and early 2009, risk materialized as never before and brought awareness to alternative portfolio management strategies, such as OBPM. Options are particularly adapted to manage portfolio risks. They can be used to augment income, enhance return potential and limit portfolio risk. As such, they have never been more viable investment tools, especially within an asset allocation and portfolio construct. In a historical portfolio context, the statistical properties of several OBPM in our analysis compare very favorably to traditional long only exposures. Q.M.S Advisors
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Option Based Portfolio Management Tail-risk Hedging and Income in a Multimodal World Option-based strategies: The strategies we examine are based on indices created and monitored by the Chicago Board Options Exchange (CBOE): The CBOE S&P 500 BuyWrite Index – BXM The CBOE S&P 500 2% Out-of the Money (OTM) BuyWrite Index – BXY The CBOE S&P 500 PutWrite Index – PUT The CBOE S&P 500 95-110 Collar Index – CLL Each of these indices has over twenty years of daily return data and follow a consistent methodology for re-establishing or rolling the option hedge upon or just prior to expiration.
We also cover three additional Option Based Portfolio Management strategies that merit consideration by investors, but for which there is not as much return information. It is important to note that these OBPM strategies are purely systematic, and that they maintain a strict and fully invested profile, holding both the long position in the index and the option position(s) at all times. Our approach is that of a portfolio manager, and not a trader, as these are all passive strategies. However, it is possible to pursue active approaches as well. Q.M.S Advisors
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Option Based Portfolio Management Tail-risk Hedging and Income in a Multimodal World Numerous Supporting Studies Over the past several years, multiple studies of OBPMS have been published—both by independent consulting firms and industry organizations. While the studies are careful not to openly endorse the strategies, the data regarding the average return and low standard deviation of returns speak for themselves. Q.M.S Advisors recently conducted its own return and risk analysis and the results continue to hold up very well compared to both long-only equity strategies and fixed income strategies. From an Efficient Frontier perspective, OBPM dominate other asset classes and strategies over the time period considered.
Prudence, Theory and Practice In the current environment, investors need exposure to risk assets to meet their required returns, to collect income or to reduce or limit risk. All of the strategies we consider provide one or more of the aforementioned characteristics. Over the time period we considered, exposure to OBPM strategies brought both solid returns and risk reduction characteristics to a well diversified portfolio. Reliable return enhancing and/or risk reducing strategies that can be implemented in a costefficient manner should be considered at the Strategic Asset Allocation level. Q.M.S Advisors
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Option Based Portfolio Management Tail-risk Hedging and Income in a Multimodal World Strategic Asset Allocation and Investability Q.M.S Advisors’ view is that reliable portfolio management approaches rest upon sound Investment Policy Statement (IPS) and Strategic Asset Allocation foundations. This is also what makes ad hoc option overlays or trading so tactically challenging. Without being formally addressed in the IPS, adding option positions informally introduces serious timing issues as well as potentially serious disruption to the formal asset allocation.
Q.M.S Advisors’ believes that when OBPM strategies are formally examined and considered, investors can and should make permanent allocations to them because of their superlative long term risk and return characteristics. Academic research supports the stylized fact that implied volatility has been and most likely will remain higher than realized volatility over the long run. Historically, OBPM strategies have dominated the efficient frontier.
OBPMS are highly investable. Option and futures trades are executed on deep, transparent, reliable, efficient and extremely liquid markets. Unlike Hedge Fund strategies, OBPMS offer full transparency as to the investment methodology and associated payoff characteristics . They are also available in vehicles that offer daily or even continuous liquidity. Q.M.S Advisors
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Option Based Portfolio Management Tail-risk Hedging and Income in a Multimodal World RATIONALE
Whether considered on a standalone or total portfolio basis, OBPM offered compelling statistical properties
Based on audited historical data from Libor 3Month USD 01.01.1989 to 28.09.2012 Historical Returns Historical Volatility Historical Skewness Historical Kurtosis Tracking Error Sharpe Ratio Maximum Drawdown Up Market Capture Down Market Capture Correlation to the S&P 500 TR Index Average Beta to the S&P 500 TR Index Beta '+/-' to the S&P 500 TR Index 2
R Convexity
2.8% 0.1% 0.03 2.21 0.00
0.01 0.00
S&P 500 TR Index
7.4% 18.2% -0.26 12.01 0.0% 0.25 -59.6% 100% 100%
CBOE S&P 500 BuyWrite Index
CBOE S&P 500 2% OTM BuyWrite Index
CBOE S&P 500 PutWrite Index
CBOE S&P 500 95110 Collar Index
8.2% 9.1% 9.7% 5.5% 12.8% 14.5% 11.9% 11.4% -0.73 -0.59 -0.76 -0.07 25.25 17.44 31.09 5.83 8.4% 6.2% 9.5% 9.5% 0.42 0.43 0.57 0.24 -43.5% -48.6% -40.2% -39.6% 53% 75% 44% 64% 79% 89% 71% 86% 0.91 0.95 0.88 0.89 0.64 0.76 0.58 0.56 Y = 0.64X -0.07 |X| Y = 0.76X -0.05 |X| Y = 0.58X -0.07 |X| Y = 0.56X +0.02 |X| +0.0006 +0.0005 +0.0007 -0.0001 0.84 0.91 0.78 0.80 -0.065 -0.053 -0.067 0.022
Source: Bloomberg, QMS Advisors
Q.M.S Advisors
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Option Based Portfolio Management Tail-risk Hedging and Income in a Multimodal World Based on Audited Historical Data from Jan. 1st 1989 to Sep. 28th 2012
Historical Efficient Frontier 12%
Historical Returns (in % p.a.)
10%
8%
6%
4%
2%
0% 8%
10%
Libor 3-Month USD CBOE S&P 500 PutWrite Index
Q.M.S Advisors
12%
14% 16% Historical Volatility (in % p.a.)
S&P 500 TR Index CBOE S&P 500 2% OTM BuyWrite Index
18%
20%
CBOE S&P 500 BuyWrite Index CBOE S&P 500 95-110 Collar Index
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Option Based Portfolio Management Tail-risk Hedging and Income in a Multimodal World Based on Audited Historical Data from Jan. 1st 1989 to Sep. 28th 2012
Relative Performance 1000 963.5 900 856.3
700
699.7
600
581.2
500 400
375.4
300 200 100
S&P 500 TR Index CBOE S&P 500 2% OTM BuyWrite Index CBOE S&P 500 95-110 Collar Index
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Jan-91
Jan-90
0 Jan-89
Growth of USD 100.-
800
CBOE S&P 500 BuyWrite Index CBOE S&P 500 PutWrite Index
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Option Based Portfolio Management Tail-risk Hedging and Income in a Multimodal World Based on Audited Historical Data from Jan. 1st 1989 to Sep. 28th 2012
Q.M.S Advisors
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Option Based Portfolio Management Tail-risk Hedging and Income in a Multimodal World
10%
0%
0%
Proba. Dist. F(). S&P 500 TR Index Proba. Dist. F(). CBOE S&P 500 PutWrite Index Cumul. Dist. F(). S&P 500 TR Index Cumul. Dist. F(). CBOE S&P 500 PutWrite Index
Q.M.S Advisors
30%
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100% PDF: Probability Dist. Function (%)
Proba. Dist. F(). S&P 500 TR Index Proba. Dist. F(). CBOE S&P 500 2% OTM BuyWrite Index Cumul. Dist. F(). S&P 500 TR Index Cumul. Dist. F(). CBOE S&P 500 2% OTM BuyWrite Index
50%
-6%
PDF: Probability Dist. Function (%)
Proba. Dist. F(). S&P 500 TR Index Proba. Dist. F(). CBOE S&P 500 BuyWrite Index Cumul. Dist. F(). S&P 500 TR Index Cumul. Dist. F(). CBOE S&P 500 BuyWrite Index
CDF: Cum. Distrib. Function (%)
5% 5%
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CDF: Cum. Distrib. Function (%)
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PDF: Probability Dist. Function (%)
Based on Audited Historical Data from Jan. 1st 1989 to Sep. 28th 2012
Proba. Dist. F(). S&P 500 TR Index Proba. Dist. F(). CBOE S&P 500 95-110 Collar Index Cumul. Dist. F(). S&P 500 TR Index Cumul. Dist. F(). CBOE S&P 500 95-110 Collar Index
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Option Based Portfolio Management Tail-risk Hedging and Income in a Multimodal World Based on Audited Historical Data from Jan. 1st 1989 to Sep. 28th 2012
Jan-12
Jan-11
Jan-10
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Maximum Drawdowns
0%
Maximum Drawdowns (in %)
-10%
-20%
-30%
-40%
-50%
-60%
-70% S&P 500 TR Index CBOE S&P 500 2% OTM BuyWrite Index CBOE S&P 500 95-110 Collar Index
Q.M.S Advisors
CBOE S&P 500 BuyWrite Index CBOE S&P 500 PutWrite Index
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Option Based Portfolio Management Tail-risk Hedging and Income in a Multimodal World Source of excess returns and sustainability There are three sources of return inherent to the OBPM strategies we presented. Two of the return streams are commonly earned by investors, namely the Treasury bill return and the downside returns to the S&P 500 stock market index. Given that these two market exposures are widely held and understood, we traditional beta exposures.
In addition to the traditional beta exposures, investors in OBPM strategies earn returns from an exotic beta source: equity market volatility. The source of the excess returns to this strategy comes from the tendency of index options to trade at prices above their fair value. As the demand for index options is high, and the natural number of options sellers is low, the buyers of options tend to pay a premium for the ability to insure against falling stock prices. In options lingo, the implied volatility tends to trade at a higher level than the realized volatility. Sellers of index options, over long periods of time, earn this risk premium of the excess of implied volatility over realized volatility as compensation for selling volatility. Notice, in our next slide, that realized volatility rarely exceeds implied volatility over a 1-month period. We believe that investors in OBPM strategies will continue to earn the volatility risk premium, as buyers of index put options seem to be willing to pay for insurance, while sellers of index put options continue to demand a risk premium to provide this insurance coverage.
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Option Based Portfolio Management Tail-risk Hedging and Income in a Multimodal World Based on Audited Historical Data from Jan. 1st 2005 to Sep. 28th 2012
30 Days Historical VS Implied Volatilities 100%
30%
90% 80%
10% 0%
60%
-10%
50% 40%
-20%
30% -30% 20% -40%
10%
Volatility Differental RHS (in % p.a.)
Sep-12
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-50% May-05
0% Jan-05
Volatility (in % p.a.)
70%
Volatility Differential (in % p.a.)
20%
S&P500: 30 Days Implicit Volatility in % p.a. X=100%
S&P500: Historical 30 Days Volatility in % p.a.
Q.M.S Advisors
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Option Based Portfolio Management Tail-risk Hedging and Income in a Multimodal World Based on Audited Historical Data from Jan. 1st 2005 to Sep. 28th 2012
Q.M.S Advisors
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Option Based Portfolio Management Tail-risk Hedging and Income in a Multimodal World Option Based Portfolio Management strategies are valuable tools in the investment toolbox. They can provide income, attractive risk adjusted returns and the potential for a cushion during market downturns. From Q.M.S Advisors vantage point, we see growing conviction in the marketplace for moderating long term return expectations. Combine this view with a low interest rate environment and the result is an increasing number of investors searching for higher levels of portfolio income and protection against short term volatility. One way investors are achieving these goals is by implementing indexed or active call overwriting programs against long portfolios. In this paper, our objective is to review basic strategy characteristics, risk/reward profiles and key overwriting strategy design factors. Naturally these elements should be viewed against the backdrop of overall portfolio objectives, current volatility regime and expectations for future volatility in order to optimize the strategy.
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Option Based Portfolio Management Tail-risk Hedging and Income in a Multimodal World Option Based Portfolio Management are valuable tools in the investment toolbox. They can provide income, attractive risk adjusted returns and the potential for a cushion during market downturns. Total Growth. Total growth since 1989 were 9.7% p.a. for the PUT Index, 8.2% p.a. for the BXM Index, 9.1% p.a. for the BXY Index, 7.4% for the S&P 500速 Total Return Index, and 5.5% for the CLL Index. Lower Volatility. The PUT, BXM, BXY and CLL indices all had volatility that were significantly lower than the volatility of the S&P 500 TR Index. Left-tail Risk. Over the past 23 years, the maximum drawdown for the S&P 500 TR Index was a decline of 59.6 percent, compared to less than 50% for all other indices (from -48.6% for the BXY to -39.6% for the CLL). Risk-adjusted Returns. One measure of risk-adjusted returns, the Sharpe Ratio, was 0.57 for the PUT Index, 0.43 for BXY, 0.42 for BXM, 0.25 for S&P 500 TR, and 0.30 for CLL Index. Please note that all the indexes had negative skewness. Monthly Premium Income. The average for the gross monthly premiums collected by the BXM Index was 1.7 percent and were usually richly priced. Q.M.S Advisors
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