Option Trading: How Important is Asset Allocation? Part III

Synopsis: What other bloggers are saying about the Wall Street Journal articles that describe how asset allocation has been shown to be less than promised.

Part I;   Part II

Justin Fox writes an excellent blog entitled The Curious Capitalist for Time Magazine.  He quoted from, and wrote about, Tom Lauricella's WSJ article that I recently discussed. The article considers the proposition that asset allocation was no longer a satisfactory method for managing risk. 

Justin claims it's not asset allocation as a strategy that failed, but "The main reason asset allocation failed is that it had become so
successful. That is, everybody was spreading their money across the
same myriad asset classes. So when the market panic came, it came
everywhere."
 

Very reasonable explanation.  Finding a reason for the failure of asst allocation to do its job of protecting the value of investor's portfolio, Justin agrees that it has failed.

He goes on to discuss that "the most intriguing (and disturbing) element of Lauricella's story is
the lesson some investors and consultants are drawing from it."
  Interesting discussion in its own right, that part of the post is beyond the scope of today's discussion.

***

The Wallet, a blog published under the umbrella of The Wall Street Journal, recently contributed a post entitled "Ditching Your Investment Strategy."  He asks readers whether they are ditching their long time methods in favor of something new.  And he's not referring only to asset allocation, but to 'buy and hold' as well: "After the plunge of 2008 and early 2009, many rethought their beliefs about the age-old “buy and hold” strategy as well, fleeing into gold, bonds and certificates of deposit instead."

The idea is spreading that the 'tried and true' risk-reducing investment methods of yesteryear may no longer be viable today.

***

It's understandable that those who believe strongly in the idea that asset allocation, by itself, can minimize risk are not going to give up that idea easily.  But I've seen anecdotal evidence that suggests that financial planners who remain faithful to last century's idea are slowing losing clients to those who are willing to be more aggressive when choosing an investment methodology.

But, few adopt options strategies, and the more aggressive methods that are being adopted come with increased risk.  Adopting methods that involve options – the best risk-reducing investment tools on the planet – remains near the bottom of the list of investment choices for the majority.  There's no good reason why that should continue to be true.  Along with helping rookie's get started trading options with a solid education, this blog represents my effort to change that.

Next time I'll take a close look at another newspaper article describing how some financial planers have reacted to the events of 2008.

to be continued

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7 Responses to Option Trading: How Important is Asset Allocation? Part III

  1. TR 07/18/2009 at 1:35 PM #

    Mark
    I wonder if you can shed some light on a some confusion I am having in understanding the thoretical prices of options.
    I have been comparing prices on the RUT Aug 570 call vs. The RUT Sep 570 call. These are the midpoint prices I found (from thinkorswim)
    RUT Aug 570 call – Price = $2.20 IV=24.8%
    RUT Sep 570 call – Price = $6.20 IV=25.9%
    The variance in the price (Sep price = 3.8 X Aug price) was surprising to me as I was expecting the Sep call to be about 1.4 times the price of the Aug call. They are both out of the money so there is no intrinsic value and my understanding was that time value for a 2 month option is about 1.4 (sqrt of 2) times the time value of a 1 month option. The implied volatility is only 1% different so I can’t see that as driving the difference either. What am I missing?
    Rgds
    TR

  2. rluser 07/19/2009 at 9:26 PM #

    I think you are inverting the function you should use. Theta accelerates as expiration approaches: options hold their values. You should be using a power of 2 and not 1/2. 3.8 is roughly 2 squared.

  3. rluser 07/19/2009 at 9:43 PM #

    Yikes arithmetic error (or typo). It’s not 3.8 but 2.8. Interesting that sep/aug factor is 2sqrt(2), but a quick glance at the BS PDE shows that the square root of time is an argument to the standard normal cumulative distribution fumction… so it’s neither so simple a relation as you posited nor the one I did.

  4. Mark Wolfinger 07/19/2009 at 11:21 PM #

    TR,
    I delayed responding because I’m embarrassed to admit that you have hit a temporary (I hope) blind spot for me, and I just don’t know the answer. I cannot delay any longer and must reply.
    When IV is the same, I expect the premium for an OTM call option with 63 days remaining to be 1.34 x the premium of an option with 35 days remaining (this is a 5-week expiration cycle). [SQRT (63/35) = 1.34]. If the options were priced for Monday’s opening (July 20), then the ratio is 60/32 and the SQRT = 1.37.
    TR: When there is an IV difference between the two options, before asking, you must grab a calculator and be certain that’s not the reason for what appears to be a price discrepancy. For the Sep 570 call, that 1.1% ‘extra’ IV adds 67 cents to the value of the call. That is not to be ignored.
    Even reduced by 67 cents, the Sep call is trading at much more than 1.34 x the Aug call.
    Can somebody help?

  5. rluser 07/20/2009 at 12:52 AM #

    According to my simple algebra (and the efforts of Black, Scholes, et al), the ratio of Csep/Caug should be near [(time remaining)DELTAsep – RHOsep]/[(time remaining)DELTAaug – RHOaug] and let us assume the effect of RHO is small (especially at present).
    So
    Csep/Caug =~ (time remaining)(DELTAsep/DELTAaug)
    I do not see a way to factor the time remaining out of the CDF (though I admit it’s been a while since I’ve solved many theoretical statistics problems).
    The above formulation leaves time lurking in the calculation of delta, but as it is a limit of the integration, it is not at all as simple as a power function.
    I welcome correction and expansion.

  6. rluser 07/20/2009 at 1:16 AM #

    meh… obviously the times remaining need a subscript and result in a ratio… not clear from the way i wrote it

  7. TR 07/20/2009 at 6:22 AM #

    Mark, rluser
    Thanks for your replies. The only thing I could think of was a dividend distribution before the Aug expiry which would lower the price for the Aug option and throw off the ratio’s.
    I searched to find out if there were any dividend distributions for RUT, but I think it is a straight index without any distributions. I went looking on the internet to see if RUT makes a dividend adjustment to keep in step with companies on the list that pay dividends but I could not find anything useful.
    Rgds
    TR