To avoid a public debate about what I know (and don't know) about modern portfolio theory (MPT) and the capital asset pricing model (CAPM), I'm going to stay on safe ground here by using Seeking Alpha's description of alpha:
'Alpha' is a finance term referring to a stock's performance relative to the market; it's used more loosely by fund managers to describe beating their index - so every stock picker is essentially "seeking alpha."
Alpha can also be thought of as the y-intercept of a graph showing the change in the value of a managed portfolio relative to the change in the value of an appropriate index over a number of time periods.
Let's focus on that y-intercept a bit more. Say I want a 1% alpha relative to the S&P 500 index on a monthly basis. Yes, I said monthly (which is 12% annually).
A 1% alpha means that if the S&P 500 is unchanged (zero) for the month, the y-intercept will be 1%. So how do I get my 1% return that month if the market is flat?
One approach might be to buy an ETF that tracks the S&P 500 and then write a covered call having one month to expiration. At typical S&P 500 volatility, it's fairly easy to consistently find an out of the money strike price each month that yields at least 1% in time premium.
Of course, those familiar with options will point out that a covered call has the disadvantage of exposing the investor to all of the downside while offering only limited upside gain in return.
The graph illustrates how the profit flattens out once the underlying stock (or ETF) rises above the strike price of the option. One needn't be a sophisticated investor to ask why anyone would expose themselves to this much risk in return for rather limited upside.
The answer has to do with managing the portfolio's value as the index changes to either side of zero (i.e., goes up or down). This is a matter of adjusting and controlling beta, which is an aspect I intend to go into in future articles.
For now, the intended takeaway is this: When constructing and managing a portfolio to maximize alpha, it can be very helpful to start by considering which components of the portfolio are capable of generating a return in a flat market.
Disclosure: I am long SPY.