The information content of equity option spread series and the assessment of investor risk appetite.

Author:Zera, Stephen

    Modern portfolio theory has frequently been interpreted by investment professionals as a justification for encouraging their clients to pursue buy-and-hold investment strategies. While the diversification aspects of modern portfolio theory are solidly grounded in statistical theory, the implication that the creation of a well-diversified portfolio will enable an investor to successfully hold that portfolio for extended periods of time has been shown over the last decade to be, at best, highly questionable. The presumption that past equity market performance will necessarily eventually be replicated conveniently minimizes the catastrophic consequences associated with the lengthy time horizon that may be necessary for the replication to occur. Simply stated, many would rationally consider 10 years to be the "long run". The consequences associated with the inevitable severe market downturns have too often been ignored.

    Investment advisors typically attempt to assess the risk tolerance of their clients so as to provide their clients with some degree of comfort with the portfolios they hold. These assessments may involve a determination of the proportions of their portfolios that they wish to have allocated to various asset classes. Within the equity class, for example, a beta comfort level may be established. The greater the accuracy of this beta comfort level estimate, the more likely clients are to be comfortable with the outcomes of their equity allocations.

    Within the equity asset class, greater precision in estimating the risk tolerance of clients will certainly result in greater client comfort with their equity investment outcomes. The more objective this estimate, the more accurate it is likely to be. That is, the less subjectivity, the better. This paper proposes a clear and highly objective method of ascertaining the equity investment risk tolerance of investors. As will be explained, an equity option spread position may be chosen by an investor that will provide the greatest degree of comfort possible for the investor. The investor may easily and objectively examine the relative advantages and disadvantages of multiple spread positions before making a choice. This methodology also presents trading-based investment opportunities that may be used to effectively diversify the risk associated with the conventionally recommended buy-and-hold investment strategies.

    Using equity options to hedge stock positions may provide investors with a level of comfort with their investments, however this comfort comes at a great expense. This is true whether an investor is using protective puts to hedge a long stock position or using long calls to hedge a short stock position. If an investor were to always hedge using the nearest month option contracts, the monthly costs of hedging would likely be astronomical. Also, using more distant month options to hedge stock positions could also prove to be very expensive. Some might argue that writing calls to offset the high cost of protective puts (creating collars) would be wise. However, collars are simply inefficient versions of spreads, that is to say more efficient strategies will attain the same result at a lower cost. Others may argue that hedging is too expensive and should not be done. This does not address the concerns of many investors who rationally fear the catastrophic destruction to wealth that markets on occasion bring to bear.

    An investment technique that would provide investors with well-defined maximum and minimum performance results may allow investors to more comfortably maintain equity exposure for longer time horizons than they might otherwise be able to. If spread trading strategies were to be used, investors could comfortably maintain either bullish or bearish positions without the fear of a large move against their position severely diminishing their wealth. Also, the often tremendous expense associated with using protective puts to hedge long stock positions or protective calls to hedge short stock positions could be avoided.


    To determine whether a specific investment strategy is successful, the return performance of a buy-and-hold strategy is usually used as the benchmark against which the performance of the proposed investment strategy is compared. Conceptually, modern portfolio theory has frequently been cited as a justification for encouraging investors to pursue the buy-and-hold strategy. A majority of the empirical studies have also supported such a simple strategy with evidence that the returns of a buy-and-hold strategy are superior to those of many active trading strategies. On the contrary, some studies did provide interesting results that prove otherwise.

    One example is an interesting study by McIntyre and Jackson (2007), which shows that covered call positions generate returns greater than those of buy-and-hold strategies. In this paper, the authors first demonstrate that entering a covered call position is like substituting a riskless bond for part of the underlying asset. In theory, the expected returns on the underlying assets (with the buy-and-hold strategy) should exceed those of the covered call position. The authors continue the inquiry with a Monte Carlo simulation and find that the mean returns and the volatilities from the covered call positions in all cases were indeed less than those of the buy-and-hold positions. Interestingly, the case-by-case results show that the covered call positions outperform the buy-and-hold strategy relatively frequently, with around 20% to 40% of paths with covered call returns in excess of buy-and-hold returns. The authors then follow up with an empirical analysis on real data in the UK. They find that in almost all scenarios, covered call writing strategies generated better returns more frequently than the buy-and-hold strategy.

    Another example is the paper by Shilling (1992), which suggests market timing can generate better returns than a buy-and-hold strategy. As specified in the paper, the most important reason for advocating a buy-and-hold strategy is that stock prices haven't risen in a smooth pattern, but in jumps, and investors who are in and out of the market are likely to be out at times of great appreciation. Most investors rightfully believe that they can't successfully time their exits from and entrances into the market. As a result, they believe that the buy-and-hold strategy is the best alternative for them. However, Shilling's analyses demonstrate that investors who either take short positions or stay...

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