Options: Can a Synthetic Portfolio Outperform the S&P 500 Index?

Includes: MMM, SPY
by: Tom Armistead

Is it possible to outperform using options? More importantly, is it possible to outperform with a lower standard deviation? This article explores the performance potential of a synthetic portfolio, where options are used as a substitute for share ownership, and demonstrates that it is possible to construct a portfolio that will theoretically outperform the S&P 500 index, and with a lower standard deviation.


Assuming that the S&P 500 will have future distributions of increase/decrease similar to the 1950-2010 period, and that beta accurately reflects the relationship of individual share movement to the S&P 500 index over time, a spreadsheet was constructed that simulates 500 cycles and produces an expected return for an options strategy. That approach was applied to a number of companies, and in the process I found that positions such as the following have properties of stability and outperformance that offer interesting possibilities:

Long 10 MMM Jan 2012 75.0 calls @ 18.70
Short 9 MMM Oct 2011 100.0 calls @ 2.57
Short 4 MMM Oct 2011 80.0 puts @ 2.57
Holding sufficient cash to secure 5 of the puts sold

Sample Output

The position reflects a modestly optimistic view. The investor is net long, willing to reduce his exposure if the stock climbs, or to increase it at lower prices. He is holding substantial cash, 72% in the position described. He is assumed to buy at the ask and sell at the bid, paying 9.95 per trade plus .75 per contract. His cash is invested in an ETF that seeks maximum return consistent with safety of principal and daily liquidity, returning 0.76% annualized. Here's the output of the model:

The results shown are gratifying. The strategy beats the S&P 500 by almost 4% and the standard deviations are very similar. Similar positions can be constructed with other stocks, and although the details vary, in the aggregate they work along similar lines. Here's a chart of the MMM example:

Reservations and Questions around Assumptions

Each leg of the strategy was tested individually, and predictably none of them outperfomed in isolation. The model ends the trade at the first options expiration, and considerable care was taken to be sure that the small amount of time value remaining on the long leg was properly computed.

Under adverse market conditions, volatility increases, and with it, the time value of options positions. Projecting volatility and the shape of the skew or smile under hypothetical stress presents difficulties. The model developed takes a conservative view of this phenomenon. Assumptions of higher volatility under stress would make the strategy more attractive.

The scenario displayed includes percentiles 0-100; that is, it reflects the entire range of historical increase/decrease for the index, with the worst case assigned to 0 percentile and included. This model always offers you a shot at going back to March 2009. The position shown outperformed any symmetrical scenario - 1-99, 5-95, 16-84, etc. It also outperformed negative asymmetrical scenarios such as 0-80. 0-80 is a difficult scenario, nothing really good happens, but bad things happen fairly frequently. The S&P 500 returns 1 or 2% for 50 years, including dividends, with deplorable volatility. The strategy shown returns almost 6% under that scenario.

MMM has a beta of .80. Raising that reduced the advantage - if MMM had a beta of 1.5 the model would then predict it would perform the same as the S&P.

Projected results were sensitive to tweaking. Adding or subtracting a few contracts or units of cash changed things a little faster than I thought they would. Similar results could be achieved with other companies, such as VZ or PG, where the common elements were low beta and dividends. VZ performed suspiciously well. Attempts to replicate the results using SPY were not successful: the model gave favorable results if the investor bought out of the money calls instead of selling them.

Any theoretical method is dependent on its assumptions. It's possible that these results are a laboratory curiosity, and reality will not behave as predicted. However, the rewards are sufficient to suggest experimenting with the approach in real time.

Asymmetry vs. the Bell Shaped Curve

Options pricing theory starts with the idea that share prices fluctuate in random ways, producing a tidy bell shaped curve. The reality is more complex. The market goes down faster than it goes up, but it goes up more often than it goes down. The following chart was developed from historical information.

Reality is asymmetrical. Options strategies are frequently symmetrical: we like to buy and sell equal numbers of contracts on both legs of a spread, with the same expiration date. It's easier to develop expected gains and losses. The software will do it for us, using bell-shaped curve thinking.

My guess is, that the strategy described here will work as indicated, for the fact that it is asymmetrical, and perhaps intersects an equally asymmetrical reality in ways that will prove profitable.

Investment implications

Over the past several years, my discretionary account has morphed into a synthetic portfolio, consisting of 65% options, with the balance in equities and cash. The predominant option strategy is LEAPS covered calls - long distant expiration deep in the money calls and short the same number of shorter term out of the money calls. Like any bullish leveraged strategy, it has done well over the past two years. However, it is volatile and requires attention to hedging and market timing in an effort to mitigate the risks involved.

The possibility of securing 4% outperformance with stable results is attractive. Over the coming year, as the market situation develops, I plan to gradually move toward a portfolio along these lines, looking to raise cash, reduce the sale of covered calls, and increase the sale of puts as a percentage of portfolio, being careful to maintain cash coverage as indicated.

The approach is experimental.

Disclosure: I am long MMM, PG.

Additional disclosure: I'm net long MMM and PG, by diagonal calls spreads,and short a few puts on PG. Long puts on SPY as a hedge. My portfolio contains a number of postions along the lines described,although the ratios vary.

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