John Marshall, Managing Director, Derivatives and Tactical Research at Goldman Sachs and Zem Sternberg of Lake Hill delivered a joint presentation at CBOE’s Risk Management Conference today in Bonita Springs, FL. Their very timely talk, considering the uncertainty surrounding the current interest rate environment, was titled The Unknowns about Bond Investing that Equity Options Traders Know.
Zem kicked off the presentation saying there are three questions (with answers) that must be addressed when considering options –
1. Why are options strategies considered riskier than fixed income?
He showed a chart of high yield bond performance and then compared returns of a strategy that involved selling SPX options and consistently Delta-hedging the position. The option performance had better returns with lower risk. He also explains that to understand the riskiness of an option strategy someone needs to understand the full process.
2. What are the stress test unknowns?
The stress test unknown is basically the process behind achieving returns.
3. Are expectations in line with reality?
Reality involves the expected draw down relative to the desired risk / return profiles. For example he notes a low risk strategy that is expected to return 10% could be expected have almost a 20% draw downs.
John Marshall took over and covered four topics –
1. The outlook for return distributions in Bonds and Equities
He used almost 100 years of bond yields and P/E ratio data (1919 to present) to demonstrate that bond yields are low relative to history. He also notes that over the last 35 years we have experienced stronger returns for bonds than over a longer period of history. There is also more downside skew to returns over the long term than over recent history.
This exercise was also performed with S&P 500 returns and there is also excess downside risk relative to recent history. However, when considering option pricing, the market is actually reflecting a more bearish outlook than recent history.
2. The Bond Buyers Equity Basket: a high yield alternative to bonds
He listed a group 100 high free cash flow stocks. As a group they yield on average 7% free cash flow. These stocks are considered an alternative to a fixed income portfolio and were the basis of the next section regarding portfolio construction.
3. Portfolio Construction and the importance of free cash flow
He then breaks out selling monthly puts on high free cash flow stocks resulted in superior returns to the total return for the S&P 500. The point is that stock selection for option selling strategies may be a key to successful returns. He also noted that if the strike selection is based on free cash flow levels that returns increase.
4. Tools for tactical trading: Systematic comparisons of credit, equity, and options
After discussing very long term data, he changed gears a bit to focus on shorter term trading. He noted that comparing S&P 500 returns to High Yield bonds is not a good apples to apples comparison. However, he notes the relationship between Investment Grade bonds and the S&P 500 is a useful equity market signal.