Author Topic: Market Neutral Strategy matching the S&P  (Read 3051 times)

Ross812

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Market Neutral Strategy matching the S&P
« on: July 30, 2018, 11:15:28 AM »
My father approached me to look into into market indexed annuities. These annuities essentially give the holder a percentage of market upside up to a cutoff and protect the holder from any market downside. In this case, it was 70% of market upside up to 12% with no downside. I looked into the annuities and found out they were essentially a repackaged market linked CDs (MLCDs) sold by banks in 250k to 1M dollar increments. The MLCDs had better terms, so i figure the insurance company is keeping a bit of the upside for their trouble plus adding some heavy origination fees for the annuity to pay their salesmen.

I started looking if there was a way to accomplish the same thing on more favorable terms myself. The objective was to provide capital preservation while still participating in the market. I came up with a strategy of laddering 1 to 4 yr CDs, AA, and AAA debt offered on the secondary market, then using the interest proceeds to buy long dated out of the money LEAP options on the the S&P 500 index through XSP. I chose XSP over SPY because the options are European Style (non-callable), settled to cash, and the underlying index is adjusted for dividends. 

To mirror the MLCD my father was looking into you would essentially buy ATM calls and sell OTM calls 12% above the market price.

I created a spreadsheet to backtest the strategy and found it is far better to by options further OTM to lever the 500k. Here is the distribution of SP500 returns since 1825:


A sample 500K portfolio bought at the beginning of 2018 would consist of:
500k in a 1-4yr bond ladder yielding ~3.1%     
15.5k of Jan '19 LEAP options on XSP with a strike ~10% OTM which works out to be 31 contracts with a $300 strike purchase at ~$500 (SP500 was at ~$2700).

31 contracts at $300 represents exposure to 31*100*$300 = $930k for any movement above 10% in the underlying index for the year which represents about 186% leverage.     

My backtesting to 1928 is showing stupid returns:
5yr - CAGR - 12.46%; 80% confidence between 4 and 21% with a max of 29% and a min of 1.5% 
10yr - CAGR - 12.33%; 80% confidence between 7 and 17% with a max of 22% and a min of 4%
30yr - CAGR - 12.26%; 80% confidence between 10 and 14.5% with a max of 16% and min of 9%

This strategy would be best in a IRA as the tax consequences on the bond proceeds would eat into returns. What am I missing here?

   
96% Fixed Income CDs, Muni, Corporate Debt - 4% SPX Options


Pelagic

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Re: Market Neutral Strategy matching the S&P
« Reply #1 on: July 31, 2018, 03:09:21 PM »
I'm curious why you're not also laddering the duration of the options? Wouldn't it make sense to be long options at a variety of expiries out to the longest dated call you can buy?

Interesting post.

no_free_lunch

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Re: Market Neutral Strategy matching the S&P
« Reply #2 on: July 31, 2018, 03:39:12 PM »
Thanks for posting.  This is not a bad strategy, especially for somebody who can't weather a decade long downturn.

When you backtest, if I understand correct, you are using current vix level and it's low historically.  So that might be inflating your returns a bit.  Still not a bad strategy.

Ross812

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Re: Market Neutral Strategy matching the S&P
« Reply #3 on: August 01, 2018, 09:35:33 AM »
That is a good point about the VIX being historically low right now. I checked some trades earlier this year on SPX options which I have traded for a while and it seems like LEAPS are priced off the interperprolation between the two realized volatility indices which correspond to their expiration date. i.e I bought some $300 strike SPX LEAPS on April 9th with 240 days till expiration. The 6 month vol index was 15.2% and the 12 month was 12%. The black scholes model:
 
http://www.cboe.com/framed/IVolframed.aspx?content=https%3a%2f%2fcboe.ivolatility.com%2fcalc%2findex.j%3fcontract%3d96E5FB36-7EDC-4485-A010-02D7284CE7EC&sectionName=SEC_TRADING_TOOLS&title=CBOE%20-%20IVolatility%20Services

Says implied volatility was 13.2 based on what I paid. The price of a the 12 month LEAP option should correspond to the 12 month volatility index.



8ish years of data can be downloaded here:  https://us.spindices.com/index-family/risk-indicators/realized-volatility

Playing with the black scholes model, it looks like a 365 day call option costs:

$4.5 @11% Vol. - back test 10yr CAGR - 13.6%
$7.8 @14.4% Vol. - back test 10yr CAGR - 8.2% (average 1 yr Vol. over time)
$13.4@20% Vol. - back test 10yr CAGR - 4.8%
$18.5@25% Vol. - back test 10yr CAGR - 3.5%

I think I need to figure out a way to backtest the strategy using implied volatility over time versus the return for the market that year. Laddering the LEAP options might be one way to take advantage of a more normalized volatility profile rather than getting lucky and buying when volatility is low. 








96% Fixed Income CDs, Muni, Corporate Debt - 4% SPX Options

clutch

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Re: Market Neutral Strategy matching the S&P
« Reply #4 on: August 01, 2018, 01:18:43 PM »
I think one approach you could take is to think about in which scenarios this strategy could "blow up" or underperform, if ever?

aws

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Re: Market Neutral Strategy matching the S&P
« Reply #5 on: August 01, 2018, 03:33:40 PM »
Does your math imply that the average return over 100 years on a 12 month S&P 500 call option is 300%?  It seems like it if you are getting 12% returns on the entire principal while risking only the 3.1% interest payments on the options.  I haven't done the math but that just seems really unlikely that options could have such a high expected return.  Wouldn't you get mind boggling numbers if you ignored the whole CD thing and just say bet 10% of your money annually on the options?

no_free_lunch

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Re: Market Neutral Strategy matching the S&P
« Reply #6 on: August 01, 2018, 03:46:23 PM »
I think one approach you could take is to think about in which scenarios this strategy could "blow up" or underperform, if ever?

One scenario is a slow rising, low volatility market.  For instance, if the market grinds forward 5% one year, 0% the next, 10% the year after, plus dividends, you are not getting any of that gain if you have 10% OTM calls.

Ross812

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Re: Market Neutral Strategy matching the S&P
« Reply #7 on: August 01, 2018, 06:04:47 PM »
Does your math imply that the average return over 100 years on a 12 month S&P 500 call option is 300%?  It seems like it if you are getting 12% returns on the entire principal while risking only the 3.1% interest payments on the options.  I haven't done the math but that just seems really unlikely that options could have such a high expected return.  Wouldn't you get mind boggling numbers if you ignored the whole CD thing and just say bet 10% of your money annually on the options?

That's the way the math works. Take my example from this year. Buy the 31 $300 strike option contracts for $5. If the market goes up by 15% ($310) your contacts are worth 31k or a 6.2% gain on the 500k principal. The market goes up 20%, you make 14.9% on the principal. Historically the market exceeds 20% returns 25% of the time and 10% returns 45% of the time. The 12% (probably 8-9% with normalized volatility) is really lumpy but there is no downside risk to the principal other than inflation risk.
96% Fixed Income CDs, Muni, Corporate Debt - 4% SPX Options

no_free_lunch

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Re: Market Neutral Strategy matching the S&P
« Reply #8 on: August 01, 2018, 08:14:44 PM »
What is the ticker for this XSP product?

Ross812

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Re: Market Neutral Strategy matching the S&P
« Reply #9 on: August 02, 2018, 07:13:10 AM »
What is the ticker for this XSP product?

http://www.cboe.com/products/stock-index-options-spx-rut-msci-ftse/s-p-500-index-options/mini-spx-index-options-xsp

XSP represents 1/10th of an SPX index future. In practice I have been buying SPX options and filling odd lots (1-9) with XSP options because SPX options have more liquidity.

http://www.cboe.com/products/stock-index-options-spx-rut-msci-ftse/s-p-500-index-options

In Interactive Brokers, just search SPX or XSP under order ticket and select options.


96% Fixed Income CDs, Muni, Corporate Debt - 4% SPX Options