Can You Beat the Market? Searching for Answers. Part I

Investors want to 'beat the market,' and continue the the search for alpha (a coefficient which measures risk-adjusted performance, based on the specific security and not the entire market)

Professional mutual fund and hedge fund managers are paid big bucks to find alpha, and deliver enhanced performance to their investors.  Most are unable to beat the market on a consistent basis, and the search for alpha remains elusive.

There are those who believe actively trading in an effort to find that alpha is misguided and it's better to invest passively (thereby saving a bunch of money in trading costs and management salaries and bonuses) by owning share of index funds or ETFs.  Those funds charge very low management fees.

It's not my purpose to continue the debate over passive vs. active money management, but along the way I will mention some studies that have been made. 

Are there other ways to enhance market performance?  Can we use option based methods to produce the equivalent of alpha? That's the basis for this series of posts.

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In late August 2009, one blogger (potato) wrote that "MW has been popping up in the comments sections of a lot of blogs recently touting an options collar strategy."  I wouldn't mention this if I weren't that 'MW.'

It's true.  I've been entering into discussions, where I feel it's appropriate, suggesting that personal finance bloggers give more support to the idea of using collars as a conservative investment strategy.

Here's the background:  Most PF bloggers take the position that active investing is inferior to passive investing.  The data supports their stance.  In other words, most mutual funds cannot match the performance of the appropriate benchmark (S&P 500 Index is the most commonly used benchmark). 

Why can't those funds, operated and managed by professional money managers beat the market?  The bottom line is that they can, on average, match the market.  But, it's been shown that the costs associated with active trading plus the management fees are high enough to convert the average fund from a market matcher to an under-performer.

Sadly most of the investing public is unaware of such studies.  In addition, there are many salesmen (earning hefty commissions) for those actively managed mutual funds.  Thus, most individual investors have no reasonable method for learning about the benefits of buying shares of index funds instead of actively managed funds.  The information is widely available, but most people trust their brokers and advisors, ignoring that free information.

Studies have also shown that individual investors have a higher opinion of their performance than that performance deserves.  Along the same lines, those who believe they are doing well tend to trade more frequently.  Additional data shows that those who trade the most, underperformed the most.

Thus, not only is passive investing more likely to produce a better result for professionals, but the same is true for individuals.  Less frequent trading of stocks yields better results.

The bottom line is that personal finance bloggers, who tend to be conservative and frugal, favor passive investing.

With that in mind, I entered the conversation on several blogs, suggesting that owning option collars (buy stock, buy puts, sell calls) represents a conservative strategy that is guaranteed to minimize losses.  The trade-off is that profits are also limited and that's a big turn-off for investors who believe it's easy to out-perform the markets.

Thus, one of my responsibilities when promoting the use of collars is being able to demonstrate that they produce reasonable returns and are not cost prohibitive. That is now possible.

Our path will include covered call writing as a method for enhancing stock market returns.  It may not strictly count as 'alpha,' but the cash earned is just as spendable.

to be continued

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8 Responses to Can You Beat the Market? Searching for Answers. Part I

  1. jeff partlow 09/17/2009 at 8:38 AM #

    Looking forward to your post re possibility of achieving alpha via covered calls.

  2. Mark Wolfinger 09/17/2009 at 9:09 AM #

    No so much ‘alpha’ as enhanced returns.
    I think of alpha as profits resulting from excellent stock selection. But, if strategy selection brings home extra dollars, then to me, it’s equivalent.

  3. harbortug@gmail.com 09/17/2009 at 7:00 PM #

    Mark, you are the voice of market sensibility… If I may ask; what is you opinion of this trade please:
    I think the market will turn soon. I don’t believe anyone can time it (I can’t anyway) I am not comfortable with a market neutral play here and I don’t have the patience to sit out this pivot. Soooo, I am buying December puts pretty cheap here and “defending” my position scalping front month calls– buying about half the size of my established put position in ATM calls on sharp spikes down/ selling on pops. The front month gamma offers nice leverage, and when I finally (hopefully) get it wrong and we go into a dive the IV rush on both puts and calls and lack of gamma on the puts should soften the pain very nicely, even if I wait a bit too long–for a confirmed downtrend. I buy my puts in small batches on each upward spike then to keep track of theta burn and where I’m REALLY at, I just trade off my account balance– again my objective is solely defense as I have generally bad luck trying to daytrade for profits at a major pivot (like we’ve got here imo). I’m playing the RUT like this now. Although I could easily see 1120 or so SPX and/ or DOW 10k I don’t want to gamble the exact timing… Honest opinion, please.
    TIA, Dave

  4. Mark Wolfinger 09/17/2009 at 8:17 PM #

    Dave,
    Thanks.
    I have never considered trying anything like this, so my opinion is based on my feelings and not real experience. I’m very opinionated, but this time I don’t have have strong feelings. That said,
    1) It’s reasonable to own long calls against your long puts.
    2) With a bearish bias, it’s reasonable to take profits on those calls, when possible.
    3) The trouble that I fear ocurs if you cannot get a scalp and the market is fairly neutral for a few days. That will cost in theta. You are looking to ‘finallly get it wrong’ with the market diving. If it just sits – you also got it wrong.
    4) If you really believe vega is low now and you are getting a good price on the puts – a reasonable, but far from certain possibility – you can convert this to a pure vega/gamma play buy buying Dec calls on dips and puts on ralies. Until you own enough. But this is a big vega gamble and there is NO good reason to take this risk. Especially when realized volatility has been much lower than IV lately.
    5) The big problem – which I know you hope to have – is what to do on a decline. Do you hold and look to make several years worth of profits in one sitting – or do you scale out or spread off your longs. That’s a great problem to face, but you should have some idea of what you plan to do.
    One choice is to take some cash out of your position every so often. You may decide – and this is merely one example – to sell 20 point spreads and roll down your longs, every time you can collect X for the 20-point spread. I would not do it for less than 10, but don’t hold out for 18 either. The credit you wat to collect is a measure of your continued bearishness, but by taking dollars out all the way down, while maintaining the same number of long options is a good way to lighen your load periodicaly, and still make a fortune if the world falls apart.
    6) Bottom line, I see nothing wrong with this play. There is the dull market risk – but if you are ever going to make this play, Sept/Oct just feels like the right time.
    If we do see 1120 on SPX, you may make enough scalping calls to pay for the puts. And you may even decide to roll your puts to a higher strike with the call profits.
    Good trading.

  5. Dave 09/17/2009 at 9:14 PM #

    Marvelous, thank you. I’ve been trading this a few days now with decent results but when I mentioned it to a fellow bandit he thought I was crazy– I certainly take your input far more seriously, btw. Good point on #5… I sport a questionable (and sad) history of not letting winners run far enough… Rolling down spreads is a great idea.

  6. Mark Wolfinger 09/17/2009 at 11:01 PM #

    About cutting winners short: When you own 20 options at $2 apiece, there’s not much to fear. But when then become $10, suddenly you have a lot to lose. And what happens at $15?
    Rolling down is one way to take cash off the table, and still have a good play remaining. But know yourself. How will you feel when you sell a 20 point spread for 12 three times? Sure you took 36 points out, but you gave up as much as 24. Will you be okay with that? Personal comfort zone decision.
    It’s still a risky play. If you get no movement you will suffer.
    Good trading and good luck.

  7. Anon 09/18/2009 at 10:17 AM #

    What about buying out of the money put calendar spreads: selling front month to buy back month especially in cases where front month vol is higher than back month?

  8. Mark Wolfinger 09/18/2009 at 10:40 AM #

    There are many option strategies. Any of them can provide good returns under certain conditions, if risk is managed well.
    OTM put calendars is a good idea for bears. First this spread is rich in vega, so if the market tumbles, not only will your put spread widen as it moves nearer to being ATM, but an IV increase adds to profits.
    Obviously, a market rally hurts the position.
    One warning: Don’t be deceived by the fact that you get to sell a higher IV when selling front month options. When trading a calendar spread – it’s long vega (volatility component of an option’s premium), it costs a larger debit to buy the spread when IV is high.
    All that means is: despite the fact that IV is higher for the front-month option, when IV is elevated, the calendar spread costs more. The longer-term option usually increases in price by more than the near-term option. So selling higher IV is good – but calendar spreads are better to buy when the IV is at a lower, rather than a higher, level.
    One more point: To make a success of this method in a bearish market, it’s important to accept profits when the underlying is well-priced. Thus, even when you want to hold longer, it’s a good idea to exit the calendar spread when it becomes an ATM spread.
    Thanks for commenting.