Owning $100 of the Nasdaq 100 ETF from April 1999 to May 2009 would result in this roller coaster ride (Click on the image to enlarge):

Passive Collar

We want to compare this to the collar strategy in each of the sub-periods outlined in the graph. The title on this graph in incorrect, we are comparing one month, three month, and six month puts. (Click on the graph to enlarge.)

Here is how the passive collar strategy does:

• The dark green line is the return for the strategy of owning QQQQ and selling at the money one month calls and buying at the money one month puts. It has a steady bond-like return where $100 grows to about $140 in ten years. That is a 3.4% compounded return.
• The purple line is the return for the strategy of owning QQQQ and selling at the money one month calls and buying at the money three month puts. Here, most of the increase is in the early period, from March 1999 to March 2003. Starting with $100, it grows to about $180 in this period and then in the next six years, increases to about $190. This is a 6.6% compounded return over the ten years.
• Similarly, the turquoise line, which is the return for the strategy of owning QQQQ and selling at the money one month calls and buying at the money six month puts, rises to $275 by September 2003 and then treads water until March 2009. This is a very respectable 10.6% compounded return over the ten years.

The passive strategy is most sensitive to the put expiration. So we look at 2% out of the money puts written six months out and see how the return varies with how far out of the money the one month calls are written.

This is for the whole ten year period:

• The passive collar strategy cut the standard deviation of return by two thirds from 30% to 10%. This is a very substantial improvement.
• Of course, it also turned a losing strategy, owning the Nasdaq, to a nine to ten percent per year winner.
• The maximum drawdown for owning the QQQ was 80%, nearly impossible to recover from. The collar had a maximum drawdown of 21% for the loosest collar.
• The correlation with the underlying increases as we loosen the collar by increasing the amount that the call is out of the money.

Active Collar

(Click on the graph to enlarge.)

The upper turquoise line is the short term active strategy. It turns $100 into $300 in ten years, which is an 11.6% compounded return. All the return was made by September 2003, the strategy treads water after that.

Tomorrow, we’ll look at what it all means.

The latest Investor’s Intelligence poll was released today, and it showed the highest Bull Ratio since December 2007.  During the prior bear market, such spikes in optimism among the newsletter writers preceded a market deccline every time but once (that exception marked the end of the bear market).

Most interesting is WHY people follow those writers, or anyone else for that matter.  It isn’t because they’re necessarily right more often than not.  In fact, when they engage in group-think, they’re wrong more often than not.

More likely is that they gain a following because they appear confident.  The New Scientist posted an article today which explains that experts who appear confident get taken more seriously than those who might have a more persuasive argument, but who stress the uncertainties in their forecasts.

This is part of the reason why those who are always bullish or always bearish maintain followers.  They can be wrong for extended periods of time, but they’re very confident in their outlook.

And it certainly explains the Cramer Phenomenon.  He’s about as good as flipping a coin, but he sure seems like he knows what he’s talking about (who could ever doubt someone with a sound-effects board?).  Next time your advisor appears cocky, you might want to take a look at some history before just handing him your money.

Source:

Humans Prefer Cockiness To Expertise

The New Scientist, June 10, 2009

In a discussion titled: “Smirking Because They Know Something” CXO Advisory discusses a paper that concludes that looking at the difference between the implied volatility of Out of The Money (OTM) puts and comparing it to At The Money (ATM) calls, the “smirk” referred to, does have real value.

Here are the main points with my comments.

• Over 90% of sample observations have positive volatility smirks, with OTM put options typically (median) implying volatilities about 5% higher than those implied by ATM call options.
• A portfolio that is long (short) the tenth of stocks with the least (most) pronounced option volatility smirks, rebalanced weekly, generates a risk-adjusted (market, size, book-to-market) annual return of about 15% before transaction costs.

So if you buy the 10% of stocks with the smallest smirk and sell the 10% with the largest smirk and rebalance the portfolio weekly, you may earn 15% before transaction costs.

• This predictability persists with generally diminishing returns for holding (rebalancing) periods up to about six months.

The increased implied volatility of the out of the money put option predicts poor earnings for the company for up to six months out. The paper guesses that is because knowledgeable investors prefer to buy the OTM puts when they know earnings will disappoint. That increased demand increases the implied volatility of the puts.

• Combining a rough approximation of transactions costs with bimonthly portfolio rebalancing suggests that a real trading strategy may well be profitable.
• Firms with steepest option volatility smirks tend to have the worst earnings shocks the next quarter.

So the real value of this volatility skew is for the next quarter’s earnings.

• Predictability is robust to size, book-to-market, idiosyncratic volatility and momentum effects.
• Results are consistent with an interpretation that: (1) informed traders with bad news prefer OTM put options; and, (2) the stock market is slow to incorporate the information they reveal.

Now that we know this, will the effect go away?