Tuesday, June 05, 2007

Implementing an Equity Strategy Through Options: More On Nassim Taleb

My recent post on the review of Nassim Taleb's book, "The Black Swan," has led to some insights which have radically transformed the alternatives for implementing our equity portfolio strategy.

In that prior post, I discussed Taleb's concerns regarding the inappropriate use of statistical distributions for various financial event forecasting and/or simulation.

Following on that book review, in a circuitous fashion, my partner and I were given a fairly lengthy article about Taleb, which appeared in the New Yorker magazine several years ago.

In that piece, buried toward the end, amidst considerable qualitative reasoning by Taleb on the subject of 'once in a lifetime' events, were a few jewels of investment insight. One was, a la Taleb's book, to eschew the use of normal distributions when assessing the likelihood of extreme market events, such as outsized negative or positive returns. The other was his avoidance of any equities, in favor of only purchasing puts or calls.

After considerable reflection, and the integration of the very timely comments of Professor Stephen Ross, discussed in this post, I realized that, strictly from a catastrophic event perspective, there is no scenario in which holding equities would be preferable to holding out-of-the-money call options on the same portfolio.

The only limiting factor to implementing an equity strategy in this fashion is one familiar to those who frequent casinos. Can we be fairly certain that our portfolios of call options will rise in value, above the cost of the premium, which is lost (unlike the investment in the underlying equity) each period, sufficiently frequently to avoid going bankrupt from a run of mediocre or negative portfolio performances?

After more reflection and some fairly involved quantitative Monte Carlo simulations, my partner and I have found the answer to be, "yes."

Further, once we determined that the risk of this bankruptcy is acceptable, we turned to a fairly simple, but incredibly effective strategy familiar to any casino player- banking your winnings. That is, we developed a simple approach to sweeping the positive returns back into the investment base, and making the size of each investment portfolio dependent upon various multiples of the original investment having been 'banked.' Thus, within a few periods of investing in the equity strategy via call options, we are playing with house, or the market's, money. This rapidly builds over time. The greatest risk for the strategy, as expressed through options, is a losing streak during the first 18 months. After that, the probabilities are that virtually any dry period can be weathered without losing the entire investment.

Along with the safety of implementing our equity strategy via call and put options, we realized two other transforming aspects of the new approach. By using options, rather than equities, we are able to reduce the investment required for holding a given dollar-value portfolio by roughly a factor of 20. And by more frequently investing in the strategy, using each month's selections, rather than simply running two, six-month duration equity portfolios each year, we were able to increase the expected returns by a roughly a factor of 6.

Together, the effect of using less-capital-intensive options, more frequently, have allowed us to increase the expected returns of the original equity portfolio strategy by something in the neighborhood of more than 100-fold, on a gross basis. And this assumes delta neutrality for long-dated, out-of-the-money options. In reality, our assumptions are very conservative with respect to the expected returns of such options, vis a vis those of their underlying equities. Since the original equity strategy had an expected annual return of roughly 20%, this yields a much more potent, yet safer, approach to exploiting the consistency of our large-cap equity selection process.

As a result of these recent new, and transformational, developments in our equity portfolio strategy, through the use of call and put options instead of underlying equities, we believe we will be able to forego the search for a large, institutional investor for the near term, and turn, instead, to our own capital, and that of selected high net worth individuals.

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