My initial attraction to investing was not to create a balanced, conservative portfolio, but rather excitement of day trading. I wanted to amass large sums of money without getting up from my chair, and who doesn't? It is hard to admit failure, but a few months and losses later, I realized the error of my ways. Like most, I was simply not wired to day trade. One who excels at day trading not only possess a great analytical ability, but also a superior understanding of physcology and reaction to certain high pressure situations. Realizing my failure, I began focusing solely on long term investing and using options to compensate for my reluctance to "time the market".
One of the more conservative options strategies I utilize has its roots in the efficient market hypothesis. This hypothesis states that all available information is currently priced into the stocks. According to the hypothesis, it is difficult to beat the market consistently, because the only way to do so is to both predict the future news and how this will be priced into the stock. The validity of efficient market hypothesis is the topic of much debate, but it is a good place to start for the purposes of this article. In accordance with efficient market hypothesis, each stock is just as likely to outperform or underperform the market. If no substantial news or information is realized, each stock will perform just how the general market does. Currently the S&P 500 (SPY) trades at the price to earnings of 13.22 based on forecasted earnings of $102.40. This implies that the index should yield 7.56%. Since 5.56% (7.56% - Current yield of 2.00%) of these earnings are held in company reserves, the value of the company should appreciate by 5.56%. The last piece of the equation is the rate of inflation, which will effect the hard assets and future earnings of the company. The current inflation rate is about 2.5%. This implies that the value of the index will rise by approximately 8%
The chances of the market gaining exactly 8% are quite slim, even though this is what is priced in. Every day new news and information is constantly being priced in, causing the prices of stocks to fluctuate. For example, positive news out of Europe could move the markets up 10% in the matter of days, but the fact remains that negative news developments are just as likely to move the market down as positive developments are to move the market up.
The Efficient Market Option Strategy: This strategy is for investors who are risk averse and not looking for wild market swings. This strategy relies on the assumption that over the long run, the market should yield about the expected return. One can implement this strategy by selling call options at a strike price that is indicated by the market expected rate of return. As it stands to today, this would be a yearly rate of 8%. If I own a stock priced today at $100 a share, I would sell strike $108 calls.
Benefits of "The Efficient Market Option Strategy":
- Lower volatility
- Higher rate return in times of lower volatility
- Dynamic: selling higher strike calls when market may be undervalued and lower strike when market is overvalued. (Expected rate of return is always changing)
- May underperform market during periods of extreme volatility
- Risk of missing on a big run-up.
Back testing the Efficient Market Options Strategy: Over 10 years, the strategy outperformed the S&P 500 index by 0.2% annualized rate with a lower standard deviation (16.7% vs 18.3%). The chart shows The Efficient Market Options Trade executed on the S&P 500 index ETF (click to enlarge)
Implementing "The Efficient Market Option Strategy":
Index: Nasdaq 100 (QQQ)
To implement the efficient market option strategy on the Nasdaq 100, one should sell Jun'13 strike 69 calls for $3.05. This gives you a 4.75% cushion own the downside and a maximum return of 13% (including dividend payments).
Equity: Apple (AAPL)
To implement the efficient market option strategy on the Apple, one should sell April'13 strike $655 calls for $47.50. This gives you 7.9% cushion own the downside and a maximum return of 18.3% (including dividend payments). Note: The return calculation is for the 9 months between July and April, annualizing this number will result in a maximum return of 24.4%
Equity: Ford (F)
To implement the efficient market option strategy on the Ford, one should sell Mar'13 strike $10 calls for $0.41. This gives you 4.3% cushion own the downside and a maximum return of 11.3% (including dividend payments). Note: The return calculation is for the 8 months between July and March, annualizing this number will result in a maximum return of 16.9%
The efficient market options trade is not for all investors, as its purpose is to lower volatility at the expense of excess market returns. For those investors looking for a modest yet consistent rate of return while remaining in equities, the efficient market options trade may be the way to do it.
Disclosure: I am long (F).