SteadyOptions is an options trading forum where you can find solutions from top options traders. TRY IT FREE!

We’ve all been there… researching options strategies and unable to find the answers we’re looking for. SteadyOptions has your solution.

Coming to Peace With Market Volatility: Part II


On April 18th I wrote part I of this article, Coming to Peace With Market Volatility. I showed how the US equity market risk premium, defined as the annual average return of the Total Market minus the return of one-month US Treasury Bills, was a large 8.37% per year from 1950-2019. That’s the good news.

The bad news is that the annualized volatility of the market premium has been almost twice as large as the premium itself at 15%, and therefore has had a wide range of approximately -40% to +50%. Many are not fully aware of the implications volatility has on the probability of a positive outcome over meaningful periods of time. For example, below are the historical frequencies at which the US equity market premium has been positive since 1927:

 

image.png

 

As investors, our goal should be to maximize the odds that our investments meet our long-term financial goals. In order to achieve this objective, we could attempt to time the market premium (get out/in of the equity market when we think it will underperform/outperform T-Bills), but this is so difficult to do consistently that it may be imprudent to try. Alternatively, we can diversify within the equity market by giving greater than market cap weight to stocks with certain characteristics, or factors, that academic research has found to have higher expected returns and diversification benefits. This includes the higher historical average returns of Small Cap stocks vs. Large Cap stocks, Value stocks vs. Growth stocks, and stocks with high relative Profitability vs. stocks with low relative Profitability. Below are the historical frequencies of outperformance since 1926 for each factor.  Note that due to data limitations, profitability is measured since 1963. All data is from Dimensional Fund Advisors.

 

image.png

 

There are many ways investors can use this information. For the purpose of this article I’m focused on how we can use it to build a portfolio with a higher frequency of beating T-Bills than a market portfolio, as well as the frequency of a “factor tilted” portfolio beating a market portfolio. In the below chart, the factor tilted portfolio that gives slightly greater than market weighting to Small Cap, Value, and high relative Profitability stocks is referred to as “Adjusted Market”.

 

image.png

 

There are mutual funds and ETF’s available that investors could purchase that would provide similar expected returns to what is displayed in this chart. Not only would this factor tilted adjusted US equity portfolio historically have higher than market returns (average premium over T-Bills of 9.95% annually since 1950 vs. 8.37%), the data shows it would have also provided a slightly more consistent premium over 5- and 10-year rolling periods.

 

Conclusion

 

Our goal as investors should be to build portfolios that can most reliably meet the required rate of return that it will take to reach our long-term financial goals. In order to know this, a financial plan with clearly described goals is required. We should focus on only taking risks that cannot be easily diversified away, and therefore the market provides compensation for bearing. These risks include the factors mentioned in this article, including the risks of the Market as a whole and of Small Cap and Value stocks. Investors may consider adding greater than market cap weighting to these known sources of expected return for their equity portfolios.This can easily be done today at low costs with certain mutual funds and ETF’s. By simply “tilting” a portfolio to these risk factors, diversification is still maintained across roughly 3,000 stocks that make up the total market. Similar to an investors decision of how much to hold in stocks vs. bonds, an investor must consider how much they include factors in their equity allocation.

 

Jesse Blom is a licensed investment advisor and Vice President of Lorintine Capital, LP. He provides investment advice to clients all over the United States and around the world. Jesse has been in financial services since 2008 and is a CERTIFIED FINANCIAL PLANNER™ professional. Working with a CFP® professional represents the highest standard of financial planning advice. Jesse has a Bachelor of Science in Finance from Oral Roberts University. Jesse manages the Steady Momentum service, and regularly incorporates options into client portfolios.


Related articles

What Is SteadyOptions?

Full Trading Plan

Complete Portfolio Approach

Diversified Options Strategies

Exclusive Community Forum

Steady And Consistent Gains

High Quality Education

Risk Management, Portfolio Size

Performance based on real fills

Try It Free

Non-directional Options Strategies

10-15 trade Ideas Per Month

Targets 5-7% Monthly Net Return

Visit our Education Center

Recent Articles

Articles

  • How To Create Your Own Indexed Annuity

    Indexed annuities are a life insurance company product sold by insurance brokers for a commission that is based on the amount deposited into the contract. Contract performance is linked to popular indexes like S&P 500, and early withdrawal penalties typically apply for the first 7-10 years if withdrawals greater than 10% of the contract value are taken each year.

    By Jesse,

    • 0 comments
    • 877 views
  • Q&A with Mental Game Coach Jared Tendler

    QUESTION: Thank you for taking the time to participate in a Q & A session with Steady Option. Let’s start with an introduction and a little bit of background on who you are and how you got here.

    By Jared Tendler,

    • 0 comments
    • 1,101 views
  • Using TLT Options to Increase Expected Returns of a Buy & Hold Portfolio

    TLT is the iShares 20+ Year Treasury Bond ETF that seeks to track the investment results of an index composed of U.S. Treasury bonds with remaining maturities greater than twenty years. Even though US Treasuries typically act as a diversifying asset class to mainstream equities, many investors with long time horizons may not be interested in holding TLT in their portfolio because it would lower expected returns.

    By Jesse,

    • 0 comments
    • 1,313 views
  • Tax Efficient Trading Part II: Capital Gains Deferral

    In part I I illustrated how the preferential tax treatment of 1256 contracts could improve after tax returns of a PutWrite strategy over a long period of time. In this article, I’ll continue the illustration by switching from a PutWrite to an ETF BuyWrite (covered calls) strategy while holding pre-tax expected returns constant at 8%.

    By Jesse,

    • 0 comments
    • 1,617 views
  • Tax Efficient Trading Part I: The 1256 Contracts

    Cash settled index options like SPX, XSP, RUT and a few others receive special federal tax treatment where 60% of the gains are reported as a Long Term Capital Gain (LTCG) even if the contract was held for less than a year.

    By Jesse,

    • 0 comments
    • 1,599 views
  • SPY Short Puts vs. Put Spreads

    In this article I’ll be using the ORATS Wheel backtesting tool to compare the performance since 2007 of SPY short puts versus short put spreads. I’ll look at both risk and returns, and different ways of determining position size to adjust for the differences in risk between the two trades.

    By Jesse,

    • 1 comment
    • 2,406 views
  • Signs that you Are Ready to Start Investing

    If you want to build your wealth, you have to make sure that you invest your money. If you put money into a savings account and don’t earn any interest from it, this won’t work for you in the long term. Your money will lose value because of inflation, and this is the last thing that you need. So when do you invest?

    By Kim,

    • 0 comments
    • 1,732 views
  • One Year of Diversified leveraged Anchor

    I almost hate to keep saying it, but the Diversified Leveraged Anchor strategy keeps exceeding expectations and performing as designed. To remind our readers, Diversified Leveraged Anchor was created in April 2020 attempting to further increase performance, reduce risk, and to reduce volatility. 

    By cwelsh,

    • 5 comments
    • 2,813 views
  • Should I Pay Off My Mortgage Early Or Invest?

    Paying off a home mortgage early is a popular financial goal. Most people feel a level financial peace when their home is paid off that is beneficial in many ways. The most common approach to paying off the mortgage early is directly making additional principal payments to the lender on a regular basis.

    By Jesse,

    • 0 comments
    • 1,338 views
  • Option Order Execution Tips

    As a community of option traders, we all can relate to the occasional challenges of order execution. Best practices for avoiding errors as well as techniques for better potential execution will be the focus of this article.  Like countless others in the Steady Options community, I personally have traded thousands of option contracts over the last decade.

    By Jesse,

    • 17 comments
    • 2,958 views

  Report Article

We want to hear from you!


There are no comments to display.



Create an account or sign in to comment

You need to be a member in order to leave a comment

Create an account

Sign up for a new account. It's easy and free!


Register a new account

Sign in

Already have an account? Sign in here.


Sign In Now

Options Trading Blogs Expertido