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

  • Important Tips For First Time Currency Traders

    Diversifying your portfolio is important for all investors, and currency investments are a great way to do that. However, there are a lot of misconceptions and common mistakes that first time currency investors make, and this leads to big losses.

    By Kim,

    • 0 comments
    • 85 views
  • Iron Condors or Short Strangles?

    In my early option trading days, I favored selling iron condors over selling strangles. I thought that selling a strangle was too risky because the potential loss was “undefined”. I thought this made sense because this is what I’d hear from other people that were more experienced than I was.

    By Jesse,

    • 0 comments
    • 1,217 views
  • How To Be A Successful Day Trader From Home

    The good news is that if trading is your passion, then it’s possible to become a successful day trader and work from home. However, it’s not as easy as setting up shop and jumping online. There are specific steps and processes you need to have in place if you’re going to be able to make a living for yourself and have a bright career and future.

    By Kim,

    • 0 comments
    • 163 views
  • 3 Key Pieces Of Advice For New Traders

    These days, everyone claims to be an ‘expert’ on absolutely everything. Apparently, it only takes having a Twitter account to be a seasoned expert on any given subject; all in all, the Internet is full of nonsense. It’s becoming harder and harder to find legitimate answers amongst the quagmire of false information online.

    By Kim,

    • 0 comments
    • 222 views
  • Why New Traders Fail

    Our first advice to new traders is: "Learn First, Trade Later". The markets will always be there, but if you start trading without proper fundamentals, your capital will be gone very fast. The barrier to enter trading is so low today, commissions are near zero, and the whole trading game looks very promising.

    By Kim,

    • 0 comments
    • 419 views
  • Lumpy Dividends and Options

    Dividend payments, like oatmeal, may be smooth or lumpy. Smooth dividends are predictable, usually once per quarter. It is easy for options traders to believe these dividends are guaranteed, because they usually continue uninterrupted quarter after quarter. This also makes it easy to predict total return over a longer time span.

    By Michael C. Thomsett,

    • 0 comments
    • 389 views
  • 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.

    By Jesse,

    • 0 comments
    • 431 views
  • Ratio Calendar Spreads

    The ratio calendar spread is well-known to some, but for others the risk/reward aspects are not well understood. One way to cover a short position is to own 100 shares of the underlying stock. Another, more creative way is to sell a shorter-term expiration position and buy a longer-term position.

    By Michael C. Thomsett,

    • 0 comments
    • 838 views
  • Studies Vs. Real Trading

    "Who you gonna believe, me or your lying eyes?" Our members and readers know that buying pre earnings straddles has been one of our favorite strategies that produced consistent gains in the last 8 years with very low risk. Yet there is a significant number of studies showing that this strategy has a negative expectation. 

    By Kim,

    • 0 comments
    • 783 views
  • Should You Hedge or Diversify?

    Using the most popular S&P 500 ETF (SPY) to represent the US stock market, this article will look at different ways to manage equity market risk using historical ETF and options data from ORATS Wheel since 2007. We will analyze the following unhedged, hedged and allocation choices:

    By Jesse,

    • 11 comments
    • 1,165 views

  Report Article

We want to hear from you!


There are no comments to display.



Your content will need to be approved by a moderator

Guest
You are commenting as a guest. If you have an account, please sign in.
Add a comment...

×   Pasted as rich text.   Paste as plain text instead

  Only 75 emoji are allowed.

×   Your link has been automatically embedded.   Display as a link instead

×   Your previous content has been restored.   Clear editor

×   You cannot paste images directly. Upload or insert images from URL.

Loading...

Options Trading Blogs Expertido