1. Option Strategist
Option Based Portfolio Management
Equity Derivatives Solutions – S&P 500 Index
October 2012
Q M S Advisors
. .
This material does not constitute investment advice and should not be viewed as tel: 078 922 08 77
a current or past recommendation or a solicitation of an offer to buy or sell any e-mail: info@qmsadv.com
securities or to adopt any investment strategy. website: www.qmsadv.com
2. Option Based Portfolio Management
Tail-risk Hedging and Income in a Multimodal World
Enhancing Long-Term Portfolio Performance while
GOAL
Mitigating Equity Drawdown Risks
Equity markets are likely to keep on experiencing periodic, broad-based and dramatic
selloffs going forward.
Adopting an Options Based Portfolio Management approach to investing (OBPM) in
the chaotic, multi-modal market environment we entered since 2008 is particularly
pertinent.
Risk can be an abstract concept until it materializes. In 2008 and early 2009, risk
materialized as never before and brought awareness to alternative portfolio
management strategies, such as OBPM.
Options are particularly adapted to manage portfolio risks. They can be used to
augment income, enhance return potential and limit portfolio risk. As such, they
have never been more viable investment tools, especially within an asset allocation
and portfolio construct.
In a historical portfolio context, the statistical properties of several OBPM in our
analysis compare very favorably to traditional long only exposures.
Q.M.S Advisors | tel: +41 (0)78 922 08 77 | e-mail: info@qmsadv.com | website: www.qmsadv.com
Page 1
3. Option Based Portfolio Management
Tail-risk Hedging and Income in a Multimodal World
Option-based strategies:
The strategies we examine are based on indices created and monitored by the Chicago
Board Options Exchange (CBOE):
The CBOE S&P 500 BuyWrite Index – BXM
The CBOE S&P 500 2% Out-of the Money (OTM) BuyWrite Index – BXY
The CBOE S&P 500 PutWrite Index – PUT
The CBOE S&P 500 95-110 Collar Index – CLL
Each of these indices has over twenty years of daily return data and follow a consistent
methodology for re-establishing or rolling the option hedge upon or just prior to
expiration.
We also cover three additional Option Based Portfolio Management strategies that
merit consideration by investors, but for which there is not as much return
information. It is important to note that these OBPM strategies are purely systematic,
and that they maintain a strict and fully invested profile, holding both the long
position in the index and the option position(s) at all times.
Our approach is that of a portfolio manager, and not a trader, as these are all passive
strategies. However, it is possible to pursue active approaches as well.
Q.M.S Advisors | tel: +41 (0)78 922 08 77 | e-mail: info@qmsadv.com | website: www.qmsadv.com
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4. Option Based Portfolio Management
Tail-risk Hedging and Income in a Multimodal World
Numerous Supporting Studies
Over the past several years, multiple studies of OBPMS have been published—both
by independent consulting firms and industry organizations. While the studies are
careful not to openly endorse the strategies, the data regarding the average return
and low standard deviation of returns speak for themselves. Q.M.S Advisors recently
conducted its own return and risk analysis and the results continue to hold up very
well compared to both long-only equity strategies and fixed income strategies.
From an Efficient Frontier perspective, OBPM dominate other asset classes and
strategies over the time period considered.
Prudence, Theory and Practice
In the current environment, investors need exposure to risk assets to meet their
required returns, to collect income or to reduce or limit risk. All of the strategies we
consider provide one or more of the aforementioned characteristics.
Over the time period we considered, exposure to OBPM strategies brought both
solid returns and risk reduction characteristics to a well diversified portfolio. Reliable
return enhancing and/or risk reducing strategies that can be implemented in a cost-
efficient manner should be considered at the Strategic Asset Allocation level.
Q.M.S Advisors | tel: +41 (0)78 922 08 77 | e-mail: info@qmsadv.com | website: www.qmsadv.com
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5. Option Based Portfolio Management
Tail-risk Hedging and Income in a Multimodal World
Strategic Asset Allocation and Investability
Q.M.S Advisors’ view is that reliable portfolio management approaches rest upon
sound Investment Policy Statement (IPS) and Strategic Asset Allocation foundations.
This is also what makes ad hoc option overlays or trading so tactically challenging. Without
being formally addressed in the IPS, adding option positions informally introduces serious
timing issues as well as potentially serious disruption to the formal asset allocation.
Q.M.S Advisors’ believes that when OBPM strategies are formally examined and
considered, investors can and should make permanent allocations to them because
of their superlative long term risk and return characteristics.
Academic research supports the stylized fact that implied volatility has been and most
likely will remain higher than realized volatility over the long run.
Historically, OBPM strategies have dominated the efficient frontier.
OBPMS are highly investable. Option and futures trades are executed on deep,
transparent, reliable, efficient and extremely liquid markets. Unlike Hedge Fund
strategies, OBPMS offer full transparency as to the investment methodology and
associated payoff characteristics . They are also available in vehicles that offer daily
or even continuous liquidity.
Q.M.S Advisors | tel: +41 (0)78 922 08 77 | e-mail: info@qmsadv.com | website: www.qmsadv.com
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6. Option Based Portfolio Management
Tail-risk Hedging and Income in a Multimodal World
Whether considered on a standalone or total portfolio basis,
RATIONALE
OBPM offered compelling statistical properties
CBOE S&P 500 2%
Based on audited historical data from Libor 3- S&P 500 TR CBOE S&P 500 CBOE S&P 500 CBOE S&P 500 95-
OTM BuyWrite
01.01.1989 to 28.09.2012 Month USD Index BuyWrite Index PutWrite Index 110 Collar Index
Index
Historical Returns 2.8% 7.4% 8.2% 9.1% 9.7% 5.5%
Historical Volatility 0.1% 18.2% 12.8% 14.5% 11.9% 11.4%
Historical Skewness 0.03 -0.26 -0.73 -0.59 -0.76 -0.07
Historical Kurtosis 2.21 12.01 25.25 17.44 31.09 5.83
Tracking Error 0.0% 8.4% 6.2% 9.5% 9.5%
Sharpe Ratio 0.00 0.25 0.42 0.43 0.57 0.24
Maximum Drawdown -59.6% -43.5% -48.6% -40.2% -39.6%
Up Market Capture 100% 53% 75% 44% 64%
Down Market Capture 100% 79% 89% 71% 86%
Correlation to the S&P 500 TR Index 0.01 0.91 0.95 0.88 0.89
Average Beta to the S&P 500 TR Index 0.00 0.64 0.76 0.58 0.56
Y = 0.64X -0.07 |X| Y = 0.76X -0.05 |X| Y = 0.58X -0.07 |X| Y = 0.56X +0.02 |X|
Beta '+/-' to the S&P 500 TR Index
+0.0006 +0.0005 +0.0007 -0.0001
2
R 0.84 0.91 0.78 0.80
Convexity -0.065 -0.053 -0.067 0.022
Source: Bloomberg, QMS Advisors
Q.M.S Advisors | tel: +41 (0)78 922 08 77 | e-mail: info@qmsadv.com | website: www.qmsadv.com
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7. Option Based Portfolio Management
Tail-risk Hedging and Income in a Multimodal World
Based on Audited Historical Data from Jan. 1st 1989 to Sep. 28th 2012
Historical Efficient Frontier
12%
10%
Historical Returns (in % p.a.)
8%
6%
4%
2%
0%
8% 10% 12% 14% 16% 18% 20%
Historical Volatility (in % p.a.)
Libor 3-Month USD S&P 500 TR Index CBOE S&P 500 BuyWrite Index
CBOE S&P 500 PutWrite Index CBOE S&P 500 2% OTM BuyWrite Index CBOE S&P 500 95-110 Collar Index
Q.M.S Advisors | tel: +41 (0)78 922 08 77 | e-mail: info@qmsadv.com | website: www.qmsadv.com
Page 6
8. Option Based Portfolio Management
Tail-risk Hedging and Income in a Multimodal World
Based on Audited Historical Data from Jan. 1st 1989 to Sep. 28th 2012
Relative Performance
1000
963.5
900
856.3
800
700 699.7
Growth of USD 100.-
600 581.2
500
400
375.4
300
200
100
0
Jan-89
Jan-90
Jan-91
Jan-92
Jan-93
Jan-94
Jan-95
Jan-96
Jan-97
Jan-98
Jan-99
Jan-00
Jan-01
Jan-02
Jan-03
Jan-04
Jan-05
Jan-06
Jan-07
Jan-08
Jan-09
Jan-10
Jan-11
Jan-12
S&P 500 TR Index CBOE S&P 500 BuyWrite Index
CBOE S&P 500 2% OTM BuyWrite Index CBOE S&P 500 PutWrite Index
CBOE S&P 500 95-110 Collar Index
Q.M.S Advisors | tel: +41 (0)78 922 08 77 | e-mail: info@qmsadv.com | website: www.qmsadv.com
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9. Option Based Portfolio Management
Tail-risk Hedging and Income in a Multimodal World
Based on Audited Historical Data from Jan. 1st 1989 to Sep. 28th 2012
Q.M.S Advisors | tel: +41 (0)78 922 08 77 | e-mail: info@qmsadv.com | website: www.qmsadv.com
Page 8
10. Option Based Portfolio Management
Tail-risk Hedging and Income in a Multimodal World
Based on Audited Historical Data from Jan. 1st 1989 to Sep. 28th 2012
50% 100% 50% 100%
PDF: Probability Dist. Function (%)
PDF: Probability Dist. Function (%)
45% 90% 45% 90%
CDF: Cum. Distrib. Function (%)
CDF: Cum. Distrib. Function (%)
40% 80% 40% 80%
35% 70% 35% 70%
30% 60% 30% 60%
25% 50% 25% 50%
20% 40% 20% 40%
15% 30% 15% 30%
10% 20% 10% 20%
5% 10% 5% 10%
0% 0% 0% 0%
-6%
-5%
-4%
-3%
-2%
-1%
0%
1%
2%
3%
4%
5%
-6%
-5%
-4%
-3%
-2%
-1%
0%
1%
2%
3%
4%
5%
Proba. Dist. F(). S&P 500 TR Index Proba. Dist. F(). S&P 500 TR Index
Proba. Dist. F(). CBOE S&P 500 BuyWrite Index Proba. Dist. F(). CBOE S&P 500 2% OTM BuyWrite Index
Cumul. Dist. F(). S&P 500 TR Index Cumul. Dist. F(). S&P 500 TR Index
Cumul. Dist. F(). CBOE S&P 500 BuyWrite Index Cumul. Dist. F(). CBOE S&P 500 2% OTM BuyWrite Index
50% 100% 50% 100%
PDF: Probability Dist. Function (%)
PDF: Probability Dist. Function (%)
45% 90% 45% 90%
CDF: Cum. Distrib. Function (%)
CDF: Cum. Distrib. Function (%)
40% 80% 40% 80%
35% 70% 35% 70%
30% 60% 30% 60%
25% 50% 25% 50%
20% 40% 20% 40%
15% 30% 15% 30%
10% 20% 10% 20%
5% 10% 5% 10%
0% 0% 0% 0%
-6%
-5%
-4%
-3%
-2%
-1%
0%
1%
2%
3%
4%
5%
-6%
-5%
-4%
-3%
-2%
-1%
0%
1%
2%
3%
4%
5%
Proba. Dist. F(). S&P 500 TR Index Proba. Dist. F(). S&P 500 TR Index
Proba. Dist. F(). CBOE S&P 500 PutWrite Index Proba. Dist. F(). CBOE S&P 500 95-110 Collar Index
Cumul. Dist. F(). S&P 500 TR Index Cumul. Dist. F(). S&P 500 TR Index
Cumul. Dist. F(). CBOE S&P 500 PutWrite Index Cumul. Dist. F(). CBOE S&P 500 95-110 Collar Index
Q.M.S Advisors | tel: +41 (0)78 922 08 77 | e-mail: info@qmsadv.com | website: www.qmsadv.com
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11. Option Based Portfolio Management
Tail-risk Hedging and Income in a Multimodal World
Based on Audited Historical Data from Jan. 1st 1989 to Sep. 28th 2012
Jan-89 Maximum Drawdowns
Jan-90
Jan-91
Jan-92
Jan-93
Jan-94
Jan-95
Jan-96
Jan-97
Jan-98
Jan-99
Jan-00
Jan-01
Jan-02
Jan-03
Jan-04
Jan-05
Jan-06
Jan-07
Jan-08
Jan-09
Jan-10
Jan-11
Jan-12
0%
-10%
Maximum Drawdowns (in %)
-20%
-30%
-40%
-50%
-60%
-70%
S&P 500 TR Index CBOE S&P 500 BuyWrite Index
CBOE S&P 500 2% OTM BuyWrite Index CBOE S&P 500 PutWrite Index
CBOE S&P 500 95-110 Collar Index
Q.M.S Advisors | tel: +41 (0)78 922 08 77 | e-mail: info@qmsadv.com | website: www.qmsadv.com
Page 10
12. Option Based Portfolio Management
Tail-risk Hedging and Income in a Multimodal World
Source of excess returns and sustainability
There are three sources of return inherent to the OBPM strategies we presented.
Two of the return streams are commonly earned by investors, namely the Treasury bill
return and the downside returns to the S&P 500 stock market index. Given that these two
market exposures are widely held and understood, we traditional beta exposures.
In addition to the traditional beta exposures, investors in OBPM strategies earn
returns from an exotic beta source: equity market volatility.
The source of the excess returns to this strategy comes from the tendency of index options
to trade at prices above their fair value. As the demand for index options is high, and the
natural number of options sellers is low, the buyers of options tend to pay a premium for
the ability to insure against falling stock prices. In options lingo, the implied volatility tends
to trade at a higher level than the realized volatility.
Sellers of index options, over long periods of time, earn this risk premium of the excess of
implied volatility over realized volatility as compensation for selling volatility. Notice, in our
next slide, that realized volatility rarely exceeds implied volatility over a 1-month period.
We believe that investors in OBPM strategies will continue to earn the volatility risk
premium, as buyers of index put options seem to be willing to pay for insurance, while
sellers of index put options continue to demand a risk premium to provide this insurance
coverage.
Q.M.S Advisors | tel: +41 (0)78 922 08 77 | e-mail: info@qmsadv.com | website: www.qmsadv.com
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13. Option Based Portfolio Management
Tail-risk Hedging and Income in a Multimodal World
Based on Audited Historical Data from Jan. 1st 2005 to Sep. 28th 2012
30 Days Historical VS Implied Volatilities
100% 30%
90%
20%
80%
Volatility Differential (in % p.a.)
10%
70%
Volatility (in % p.a.)
0%
60%
50% -10%
40%
-20%
30%
-30%
20%
-40%
10%
0% -50%
May-05
May-06
May-07
May-08
May-09
May-10
May-11
May-12
Jan-05
Sep-05
Jan-06
Sep-06
Jan-07
Sep-07
Jan-08
Sep-08
Jan-09
Sep-09
Jan-10
Sep-10
Jan-11
Sep-11
Jan-12
Sep-12
Volatility Differental RHS (in % p.a.) S&P500: 30 Days Implicit Volatility in % p.a. X=100%
S&P500: Historical 30 Days Volatility in % p.a.
Q.M.S Advisors | tel: +41 (0)78 922 08 77 | e-mail: info@qmsadv.com | website: www.qmsadv.com
Page 12
14. Option Based Portfolio Management
Tail-risk Hedging and Income in a Multimodal World
Based on Audited Historical Data from Jan. 1st 2005 to Sep. 28th 2012
Q.M.S Advisors | tel: +41 (0)78 922 08 77 | e-mail: info@qmsadv.com | website: www.qmsadv.com
Page 13
15. Option Based Portfolio Management
Tail-risk Hedging and Income in a Multimodal World
Option Based Portfolio Management strategies are valuable tools in the
investment toolbox. They can provide income, attractive risk adjusted returns
and the potential for a cushion during market downturns.
From Q.M.S Advisors vantage point, we see growing conviction in the marketplace
for moderating long term return expectations. Combine this view with a low interest
rate environment and the result is an increasing number of investors searching for
higher levels of portfolio income and protection against short term volatility. One
way investors are achieving these goals is by implementing indexed or active call
overwriting programs against long portfolios. In this paper, our objective is to review
basic strategy characteristics, risk/reward profiles and key overwriting strategy
design factors.
Naturally these elements should be viewed against the backdrop of overall portfolio
objectives, current volatility regime and expectations for future volatility in order to
optimize the strategy.
Q.M.S Advisors | tel: +41 (0)78 922 08 77 | e-mail: info@qmsadv.com | website: www.qmsadv.com
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16. Option Based Portfolio Management
Tail-risk Hedging and Income in a Multimodal World
Option Based Portfolio Management are valuable tools in the investment
toolbox. They can provide income, attractive risk adjusted returns and the
potential for a cushion during market downturns.
Total Growth. Total growth since 1989 were 9.7% p.a. for the PUT Index, 8.2%
p.a. for the BXM Index, 9.1% p.a. for the BXY Index, 7.4% for the S&P 500® Total
Return Index, and 5.5% for the CLL Index.
Lower Volatility. The PUT, BXM, BXY and CLL indices all had volatility that were
significantly lower than the volatility of the S&P 500 TR Index.
Left-tail Risk. Over the past 23 years, the maximum drawdown for the S&P 500
TR Index was a decline of 59.6 percent, compared to less than 50% for all other
indices (from -48.6% for the BXY to -39.6% for the CLL).
Risk-adjusted Returns. One measure of risk-adjusted returns, the Sharpe Ratio,
was 0.57 for the PUT Index, 0.43 for BXY, 0.42 for BXM, 0.25 for S&P 500 TR, and
0.30 for CLL Index. Please note that all the indexes had negative skewness.
Monthly Premium Income. The average for the gross monthly premiums
collected by the BXM Index was 1.7 percent and were usually richly priced.
Q.M.S Advisors | tel: +41 (0)78 922 08 77 | e-mail: info@qmsadv.com | website: www.qmsadv.com
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