Getting huge returns on your investments by being risk neutral

[Bostrom]

According to CAPM and financial theory, you should be compensated with a higher expected return for the volatility you're ready to accept. I think I'm going to try a strategy where I put about 2-4% of my liquid assets in "out of the money" call options that are about 1-2 years to maturity. Of course I don't put all my money in these types of investments because of the risk. I don't need to know how the underlying assets will move and still I will get huge returns because I will be compensated for the risk I take. By combining options on blue chip stocks with options on mining stocks and other markets the actual returns should get closer to the expected value. I may lose all money in >50% of the options but the times I win I will win really big. I've been backtrading this strategy in Excel and came up with an average annual return of about >100% on the whole portfolio even though a lot of the money in the portfolio wasn't invested during the time.

There havn't been many serious studies about expected return on "out of the money" options, but at least I found this:

http://reducing-suffering.org/do-call-o ... d-returns/

"In theory, far out-of-the-money call options should offer extremely high expected returns, sometimes annualized rates of 100%, 200%, or more. At least one study has confirmed such return magnitudes on index options, at least when bid-ask spreads and transactions costs are ignored. "

It should be possible to calculate the expected return with this formula according to the article:
(annualized expected instantaneous option return - risk-free rate) = (expected annualized stock return - risk-free rate) * (stock price / option price) * (delta of option).

If this formula works some 2 year options should offer >1000% returns on average.

Will this strategy work in practice? Why/why not? I can't see why it shouldn't work but I can't find anyone on Google who has tried a similar strategy. I assume 1+ year options are very unpopular to trade with since people try to find faster ways to get rich quick.

[The Old Man]

... at least when bid-ask spreads and transactions costs are ignored. "

Taking these costs into consideration kills many theoretical trading strategies. Proceed with caution.

[Bostrom]

I'm aware of that. The returns are so big that the bid-ask spread doesn't matter very much. There is currently a 22 month index option with strike price 1960 and spot price 1550 and a 3,70 ask. If the market goes up 40% in the next 22 months(which isn't very unlikely if there will be a bull market) the option will give you about 5500% return.

[trfie]

A 40% increase in the next 22 months is very unlikely. We have already been in a bull market the past 8 years, which is unprecedented in its longevity. Debt is at record levels.

I would question whether your backtesting was accurate. Was it based on specific classes of stocks, namely blue-chip and mining? How did you choose those? If you already knew the performance, then the backtest is not correct. Besides, you knew how the market did in advance, so naturally if you backtest many strategies over that period of time they are going to do well.

[Bostrom]

Maybe it will be difficult for the general stock market to go up 40% in the next 22 months. I meant that on average it's quite common to see those gains in that time period. I was analysing OMXS30(Stockholm stock market index) and used data from 1986 to 2018. OMXS30 gave 8,5% average annual return during that period. In 24 months you would have gotten 40% return on OMXS30 with about 33% probability so in 22 months I would guess it would be about 25-30%. I havn't found data of old index options but I assume that the volatility and expected return would will be pretty much the same in the future. If we assume that the relationships between the strike price, spot price and option price have been the same, you would have gotten about 3500% return on average. I know that volatility changes over time and therefore also the ratios between option price and spot price but even if we consider that, the expected return would still be extremely high. If I put 0,14% every trading day(or about 3%/month) of my liquid assets in that type of option I would have averaged about 100%/year on my whole portfolio.

I also used data of XAU and combined it with OMXS30. Since I didn't found any good comparable mining stocks from 1986 I created XAU index options options with a reasonable relationship between spot, exercise price and option price. I did a very pessimistic calculation so the analysis would give me a result that was too good. The XAU option I created would only give about 6-700% expected return even though I have found options on single mining stocks that would have given you 2-3000% on average. I did a test where I put half of the invested money in each asset i.e 1,5% in each option. This would still have given me about 100% average return on my portfolio even though the XAU option gave me less return on average than the OMXS option. The volatility of the portfolio would also have been lower than if I was only buying the OMXS30 return.

[Tyler9000]

I'll start right off the bat with the disclaimer that options trading is not my area of expertise.

A family member is a full-time options trader who supports his family with his trading. Very smart guy, SW engineering degree, good with numbers, etc. He's even written some small courses on trading. Your pitch of making 100% a year is exactly the same that he was quoting me 10 years ago to try to get me on board with the same strategy, and he had lots of similar tests, examples, and anecdotes to back it up. Fast forward to now, and he's not rich. If anything, the new pressure of supporting a wife and two kids has caused him to consider shelving the options trading or at least balancing it with something that provides more consistent income.

I'll also note that observing him operate over the years I don't think this particular strategy fits my lifestyle. Watching the guy have to log in and trade on his vacation because the markets moved and he was at risk of getting wiped out was not something that seemed particularly appealing. Maybe some people like to be "on" all the time, but that's not for me.

But giving the strategy the benefit of the doubt, I'll share some advice he gave me about what he's learned. Ditch the backtests. Options trading is not nearly as mechanical as it sounds. It's all about controlling your emotions, and you can ride high for a very long time before the floor suddenly falls out from under you. Maybe start trading real-time with fake money or a small amount you can afford to lose to see how you handle it, but don't fall for your own hype.

IMHO, anyone selling a foolproof system for huge profits is lying to you.

[Seppia]

Sorry for the no-gloves comment but:
Seriously, how can one believe, in 2018, that there is a consistent way of making ridiculous returns with zero to very low risk?
I would guess anything like that would be arbed away by some HFT algorithm in no time if systematic/replicable?

Without knowing absolutely anything about what you're talking about I would think there's a 99+% chance there's either a flaw in your calculations or that you aren't seeing all risks (ie Martingale)

[trfie]

What's the volatility of this strategy over the past 1 year?

You did not explain why you are choosing mining stocks? We know that mining stocks did well. So what if whatever you choose does not do well, even if that is an index?

[Riggerjack]

I like your idea, but have a few questions.

The average payoff matters not at all if you zero out. How many times in your back testing did the portfolio zero out? If none, maybe you should check your data.

How big and fast were the falls in your back testing?

How well will you handle those losses?

For what it's worth, I think you could do very well with a small portion of your savings. I test off the charts for risk tolerance, but I wouldn't put much into your strategy, not just because of volitility, (which doesn't bother me) but because this requires too much daily attention, (which does) and the returns aren't worth losing sleep over.

[Bostrom]

The strategy with mining options was used to lower the risk. The index option strategy gave about 100%/year on the portfolio, and the mining option strategy only gave me about 30-40%/year. If I combined both assets and put 50% of the invested money in each one I was still able to get about 100%/year since one of the options sometimes "rescued" the other when the other one went to hell. By doing that I didn't get as long losing periods as I would have done if I only used one of the assets.

Since I only put a percentage of my NON-INVESTED money into options each time, the portfolio could never go to zero. I ran a test by putting 3% monthly of the non-invested money(1,5% in index, 1,5% in mining options). In the worst periods, I lost all money for about 2,5-3 years. The non-invested money of my portfolio decrease was just over 60% during that period(I don't know how the options move during the time before the exercise day. When I buy options, I treat them as "invisible" money until they give a payoff at the exercise day if they are worth anything then).

I have noticed that a lot of the options in the european market seems much cheaper than the options in the US. A 22 month index option with strike price 1960, 3,70 ask and 1550 spot means a spot price more than 400 times higher than the option price while the strike price is only 26% above spot. There are also options with lower exercise prices available that are extremely cheap. It's difficult to find those odds on most option markets. I suppose the market expects extremely low volatility at the moment. I have also noticed some cases where an option with a higher strike price, everything else equal, was actually more expensive than options with lower strike prices so there market is definitely not efficient in this case.

[phil]

+1 to what Seppia said.

In a market where you compete with computer algorithms that have way more information and are way more sophisticated than your excel sheet (sorry for being blunt), getting huge returns without significant risk is impossible. If such returns were indeed possible - and the stock options in question were therefore grossly underpriced - they would be bought en masse by such algorithms, prices would go up, etc. Basic economics.

[jacob]

@phil - You might be surprised just how many of these high-falutin professional models actually run on excel spreadsheets.

The biggest problem with the OP strategy is in ignoring the spreads and possibly also in ignoring liquidity. Far-OTM options (especially future ones) tend to be thinly traded (look at the open interest and daily volume compared to near-month ATM options) and consequently have huge spreads. This indicates that the pros don't bother spending too much effort/salary chasing them. Pros prefer trades where they can either grind by spinning the spread or where the market is deep enough to put on larger bets, neither of which are the case here.

[Lucky C]

I've been backtrading this strategy in Excel and came up with an average annual return of about >100%

Average or CAGR? A portfolio that returns -99% the first year and +299% the next year would get you an average annual return of 100% but you'd lose 97% of your money...

I ran a test by putting 3% monthly of the non-invested money(1,5% in index, 1,5% in mining options). In the worst periods, I lost all money for about 2,5-3 years.

If I understand correctly, putting in 3%/month in and losing 100% of it over 30 months (assuming flat returns in your main portfolio for simplicity) results in a loss of [edit: ~60%] of your overall portfolio...

[Bostrom]

@phil - You might be surprised just how many of these high-falutin professional models actually run on excel spreadsheets.

The biggest problem with the OP strategy is in ignoring the spreads and possibly also in ignoring liquidity. Far-OTM options (especially future ones) tend to be thinly traded (look at the open interest and daily volume compared to near-month ATM options) and consequently have huge spreads. This indicates that the pros don't bother spending too much effort/salary chasing them. Pros prefer trades where they can either grind by spinning the spread or where the market is deep enough to put on larger bets, neither of which are the case here.

I've also got the impression that the market doesn't really focus on the OTM options, especially the +1 year ones.

I've been backtrading this strategy in Excel and came up with an average annual return of about >100%

Average or CAGR? A portfolio that returns -99% the first year and +299% the next year would get you an average annual return of 100% but you'd lose 97% of your money...

I ran a test by putting 3% monthly of the non-invested money(1,5% in index, 1,5% in mining options). In the worst periods, I lost all money for about 2,5-3 years.

If I understand correctly, putting in 3%/month in and losing 100% of it over 30 months (assuming flat returns in your main portfolio for simplicity) results in a loss of 86% of your overall portfolio...

100% is CAGR. Average return was far more, but CAGR is obviously the most important. The 3% strategy is 3% of the cash I have at the moment. So if I start with 100$, I invest 3$ the first month. The second month I have 97$ in cash if I don't get any payoffs of my current options, so I invest 2,91$(97*0,03). Therefore I never suffer the really big losses in my portfolio.

[frommi]

100% is CAGR. Average return was far more, but CAGR is obviously the most important. The 3% strategy is 3% of the cash I have at the moment. So if I start with 100$, I invest 3$ the first month. The second month I have 97$ in cash if I don't get any payoffs of my current options, so I invest 2,91$(97*0,03). Therefore I never suffer the really big losses in my portfolio.

What you want to do sounds a lot like betting at the casino table. So maybe the Kelly Formula can help to find the optimal betting size for each bet. From your backtest you should have a rough idea of how big your payoff and your chance of success is, i would probably go for half the bet size the Kelly formula proposes to get a smoother return curve. And then it becomes a matter of implementation and discipline.
*EDIT* when i think about it, your monthly returns for x months are correlated, so you also have to factor that into your bet size.

[Bostrom]

Yeah, I see each investment as a casino bet, but with a positive expected return instead of a negative. As you say, I must be more careful since the payoffs correlate, so the bet size must be lower that the result I get from the Kelly formula.

I tried a strategy with 10 month options as well. The best strategy were options with a strike price about 10-15% above spot. It gave me about 300% CAGR on my portfolio, but I had to put 10% of my cash monthly in the bet, and I would never have the guts to do that in practice. The returns in the 10 month option strategy were much less correlated, so I didn't get that much losses in my total portfolio. I think the best thing is to combine options with different times to maturity and different underlying assets to lower the risk and to make the returns as smooth as possible. The problem is that options on individual stocks in general have a much crappier expected return than index options.

[frommi]

How did you estimate what the option would have cost you in your backtest, do you have real historical option prices (inkl. bid/ask data) or did you calculate the option prices with a black scholes model and past vix data?
*EDIT* And over what timeframe did you test the strategy?

[Bostrom]

It's difficult to find historical option prices. I assumed the same ratios between spot, strike and option price so the options have probably been a little bit more expensive before.

An example: OMXS9L1960(OMX index, exercise month Dec 2019, Strike price 1960) is currently selling for 4,15. Strike is 1960 and spot is 1577. The ratios as you can see are Strike/Spot=1,243, Spot/Option=380. I've used these ratios when I have created options in the past. Even though option prices are actually higher in some periods, you still get a high expected return on the options and a good return on your portfolio.

[jacob]

Could you guys PLEASE stop quoting the entire post you're responding to!

Forum rule 2) DON'T USE THE QUOTE FUNCTION AS A REPLY BUTTON! Some people use phones or textreaders to keep up, so please don't abuse the quote function. Don't quote the entire post you're responding to. Because if you do, people have to scroll through all that only to learn that you're just responding to the post above IF you're responding to the entire post (which is the case in most cases), just start your post with @theirusername. Then respond. Only use the quote function when/if responding to specific paragraphs or sentences and edit everything else out.

[frommi]

@jacob Sorry!
@Bostrom Thanks, I have the feeling that is the reason this strategy backtests so well, but i will dig into this over the weekend. I am always interested to add an uncorrelated income stream to my other systems. Did you only test this with the OMX or have you tried this with the S&P500, too? And over what timeframe was your backtest?