Seeking Alpha

How To Generate True Alpha And Beat The S&P 500

by: Noah Kiedrowski
Noah Kiedrowski
Growth, biotech, large-cap, www.stockoptionsdad.com
Summary

“Alpha” (α) – A term used to describe a strategy's ability to beat the market. Alpha is also referred to as “excess return” or “abnormal rate of return”.

92% of actively managed funds do not outperform their benchmark thus do not generate any alpha giving rise to the efficient market theory.

From 1983 – 2006, Russell 3000 had 39% of stocks were unprofitable, 64% of stocks underperformed the index and 25% of stocks were responsible for all the market's gains.

Over the past 12 months, an empirical options-based portfolio generated a 6.7%return relative to a 1.6% for the S&P 500, generating true alpha.

An options-based approach provides long-term,high-probability win rates to generate consistent income while circumventingdrastic market moves.

Introduction

“Alpha” (α) – A term used to describe a strategy's ability to beat the market. Alpha is also referred to as “excess return” or “abnormal rate of return”, eluting to the theory that markets are efficient. Thus there’s no systematic method to generate returns that beat the broader market’s returns. To illustrate this point, 92% of actively managed funds do not outperform their benchmark thus do not generate any alpha giving rise to the efficient market theory. Furthermore, over a 26-year period from 1983 – 2006, the Russell 3000 index had 39% of stocks that were unprofitable investments, 64% of stocks that underperformed the index and 25% of stocks were responsible for all the market’s gains. Effectively, there’s a 36% chance of picking a stock that will outperform the market thus generating any alpha.

Those that subscribe to the efficient market hypothesis believe that there’s no edge or advantage when it comes to picking stocks. Thus, stock picking is a binary event and boils down to a 50/50 probability or simply chance. Everything that can be possibly known about a stock is known and all the available information, technical analysis and fundamental analysis is priced into the underlying stock price. The efficient market theory may be the Achilles heel of professional money mangers’ performance and their inability to outperform their benchmarks. If the efficient market theory is correct, is stock picking a useless endeavor? If stock picking boils down to chance, is there a strategy that places the statistical odds of success in one’s favor to consistently generate alpha?

An options-based portfolio can generate true alpha while mitigating risk and circumventing drastic market moves. Selling options and collecting premium income in a high-probability manner generates consistent income for steady portfolio appreciation in both bear and bull market conditions. Sticking with dividend paying large cap stocks across a diversity of tickers that are liquid in the options market is a great way to generate true alpha over the long-term. Kohl’s (KSS), American Airlines (AAL), Bank of America (BAC), CVS Health (CVS), Bristol-Myers Squibb (BMY), Qualcomm (QCOM), Apple (AAPL) and Nike (NKE) are great examples.

Results

Below are empirical results demonstrating true alpha over the previous 12 months through bull and bear market conditions, outperforming the index by a wide margin (Figures 1, 2 and 3). An options-based approach provides long-term, high-probability win rates to generate consistent income while circumventing drastic market moves. Over the previous 12 months through both bull and bear markets my win rate percentage was 86% (255/298). Over the same period, the options-based portfolio generated a 6.7% return relative to a 1.6% for the S&P 500, outperforming the index by a wide margin (Figures 1-3).

Figure 1 – Options based portfolio return (6.7%) in comparison to the S&P 500 return (1.6%) over the past 12 months through both bear and bull market conditions.

Figure 2 – Comprehensive options metrics over the previous 12 months

Figure 3 – Dot plot summarizing ~300 trades over the previous 12-month period

Efficient Market Hypothesis

Markets aren’t always efficient and they can be irrational and become overbought or oversold. Outside of these extremes however, markets are efficient and over the long-term the vast majority of actively managed funds are unsuccessful at beating their benchmarks. As of Q1 2019, for the ninth consecutive year, the majority (64.5%) of large-cap funds lagged the S&P 500 last year. The longer the timeframe the poorer the performance, after 10 years and 15 years, 85% and nearly 92%, respectively underperformed the index (Figures 4 and 5). These dismal results hold true across large-cap, mid-cap and small-cap funds. Even if these actively managed funds happen to outperform their index, it’s due to chance and this margin of outperformance is largely negated by hefty management fees, rendering stock picking useless. Furthermore, over a 26-year period from 1983 – 2006, the Russell 3000 index had 39% of stocks that were unprofitable investments, 64% of stocks that underperformed the index and 25% of stocks were responsible for all the market’s gains. Effectively, there’s a 36% chance of picking a stock that will outperform the market thus generating any alpha (Figure 6).

Figures 4 and 5 – Time based underperformance of actively managed funds relative to the S&P 500 (Active Fund Managers Trail S&P 500)

Figure 6 – Data summarizing performance of individual stocks relative to the Russell 3000 index. Highlighting the fact that only 36% of stocks had a higher return than the index and 25% of stocks accounted for all of the market’s gains. (The_Capitalism_Distribution)

Even Distribution of Returns

If those facts weren’t compelling enough, the distribution of returns also supports the efficient market hypothesis. The S&P 500 moves in a standard distribution over time, the number of daily moves is evenly distributed. There’s an equal and even number of days where the market moved up 0.6% as it moved down 0.6% (Figure 7). The market has fluctuated between a 2% loss and a 2% gain 94% of the time. Markets move in a standard distribution over time, there is no pattern or predicable cycles over the long-term which renders stock picking to random chance or a 50/50 probability. Interestingly, the market does move up over time due to a positive skew in these data attributable to the fact that indexes are capitalization weighted. This means that successful companies receive larger weightings in the index. Conversely, unsuccessful companies receive smaller weightings and are inevitably removed from the index. This disproportionally favors successful, growing companies hence the fact that only 25% of companies account for all the market gains.

Figure 7 – Standard distribution of daily market moves of the S&P 500 for 65 years

Options Provide Statistical Edge

The only way to consistently and reliably profit from this even distribution and market behavior is via options trading. Option trading allows one to profit without predicting which way the stock will move. Option trading isn’t about whether or not the stock will move up or down, it’s about the probability of the stock not moving up or down more than a specified amount. Options allow your portfolio to generate smooth and consistent income month after month for steady portfolio appreciation. Options are a bet on where stocks won’t go, not where they will go. Running an option-based portfolio offers a superior risk profile relative to a stock-based portfolio while providing a statistical edge to optimize favorable trade outcomes. Option trading is a long-term game that requires discipline, patience, time, maximizing the number of trade occurrences and continuing to trade through all market conditions. Put simply, an options-based approach provides a margin of safety with a decreased risk profile while providing high-probability win rates.

Life Insurance Parallels

Insurance companies sell policies based on risk factors, then price these polices to their advantage. Insurance companies are betting on probabilities and sell overpriced polices above their expected losses. The insurer agrees to pay out a specific amount of money for a specific loss (i.e. death). In return, the insurance company is paid monthly premiums based on this risk-based revenue model. Insurance companies sell polices with a premium cost level that maximizes a statistical edge to the insurance company’s benefit. The goal is to collect premiums over the course of the policy and never pay out on the policies they sell. So, the probability of paying out on the policy is very low while the premiums received, over the policy lifespan will exceed your total benefit. In order to spread the potential payout risk, the insurance company will sell as many polices as possible to collect as much premium income as possible.

Option trading is much like insurance. I receive premium payments (policy payments) in exchange for selling options (insurance). I sell these options with a statistical edge (underwriting) and a high-probability of winning the trade (insurance won’t have to pay). Occasionally, options move against you (death occurred) and you’re assigned stock (insurance is paid out) however in order to spread the risk of being assigned shares, options (insurance) are sold across a diversity of tickers that include both stocks and ETFs with varying expiration dates and optimal sector exposure. Additionally, risk is mitigated by appropriate capital allocation, position sizing and holding cash reserves in the portfolio.

Conclusion

Maximizing the number of trade occurrences, position sizing, diverse sector exposure, trading stocks and ETFs and managing winning trades is essential for an options based portfolio to succeed in generating true alpha. Markets are efficient and over the long-term 92% of actively managed funds are unsuccessful at beating their benchmarks. Taken together, there’s only a 36% chance of picking a stock that will outperform the broader index. There’s no edge in stock picking, hence the efficient market hypothesis. The only way to profit from this even distribution and market behavior is via options trading. Options trading allow one to profit without predicting which way the stock will move allowing your portfolio to generate smooth and consistent income month after month. Options are a bet on where stocks won’t go, not where they will go, providing a statistical edge.

An options-based portfolio has allowed me to do something 92% of actively managed funds haven’t been able to accomplish and that’s outperform the broader index on a consistent basis despite the volatility in Q4 2018, May 2019 and August 2019. Selling options with a favorable risk profile and a high probability of success is the key. Options provide long-term durable high-probability win rates to generate consistent income while mitigating drastic market moves. I’ve demonstrated an 86% options win rate over the previous 12 months through both bull and bear markets while outperforming the S&P 500 over the same period by a wide margin producing a 6.7% return against a 1.6% for the S&P 500 with a lower risk profile. Taken together, option trading is a long game that requires discipline, patience, time, maximizing the number of trade occurrences and continuing to trade through all market conditions with the probability of success in your favor.

Disclosure: I am/we are long KSS, CVS. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Disclosure: The author holds shares in AAL, CVS, GE, KSS, SLB, TRIP, USO and X. However he may engage in options trading in any of the underlying securities. The author has no business relationship with any companies mentioned in this article. He is not a professional financial advisor or tax professional. This article reflects his own opinions. This article is not intended to be a recommendation to buy or sell any stock or ETF mentioned. Kiedrowski is an individual investor who analyzes investment strategies and disseminates analyses. Kiedrowski encourages all investors to conduct their own research and due diligence prior to investing. Please feel free to comment and provide feedback, the author values all responses. The author is the founder of www.stockoptionsdad.com where options are a bet on where stocks won’t go, not where they will. Where high probability options trading for consistent income and risk mitigation thrives in both bull and bear markets.