A long index straddle is a non-directional “volatility” trade that generates a profit when markets move sharply up or down or when volatility expands. Studies also have shown that volatility has a low, often negative correlation to equities. So, could buying straddles be the ultimate long-term hedge for an all-equities mandate? Or, more specifically, if added to an equities portfolio, would the combination produce alpha?
Countering that premise is the fact that index options almost always overstate historical volatility, which benefits the client who sells index straddles. This fact is supported by indices that track index straddle writing.
In Canada, we have the covered straddle writers’ index (MPCX), which simultaneously sells close-to-the-money calls and close-to-the-money puts against a long position in iShares S&P/TSX 60 Index Fund (XIU) and retains a cash position used to secure the short put option.
The near-term (i.e., one-month), close-to-the-money call and put options are written each month on the Monday following expiration, and are held until the following expiration date. Upon expiration, the written options are settled for cash; on the following Monday, new one-month, close-to-the-money calls and puts are written. The MPCX has been a profitable strategy over the past 15 years.
To justify buying straddles, you have to adjust the metrics of the strategy by buying 90-day straddles instead of one-month straddles, the latter of which are influenced to a greater extent by time/premium decay. And, rather than holding to expiration, you need to seek an exit point between initiation and expiry at which time the straddle is profitable.
Interestingly, when using these metrics, we find that long straddles frequently have a point at which they are profitable prior to expiry. Using data from MPCX going back to March 1997, I have constructed a theoretical $100,000 portfolio that combines the purchase of 90-day index straddles with short-term treasury bills.
Approximately 5%-7% of the capital was deployed to purchase 90-day index straddles; if there was a closing value prior to expiration at which the straddle was profitable, the position would be closed and a new position would be entered into on the Monday following the normal expiration of the initial straddle.
In the 15 years between March 1997 and June 2012, the portfolio would have purchased 60 90-day straddles, of which 91.67% of the positions would have experienced some profit prior to expiration. But that high frequency of potential profitability does not imply success. Rather, it simply means that 91.7% of the positions could have been closed out with a minimum 1% profit.
Still, that is not a high enough return to compensate for the losses that would have occurred 8.1% of the time. In fact, my hypothetical $100,000 portfolio following the aforementioned strategy would have declined to $53,723 over the 15-year period.
The highest return came from a minimum return assumption of 85%, which occurred 31.7% of the time and generated an ultimate portfolio value of $262,792 (6.7% compounded annually). But that isn’t necessarily the optimal strategy in finding an equities/straddle combination that generates “alpha” (which arises from combining negatively correlated but profitable investments in a single portfolio).
The optimal model appears to be one in which the return assumption approximates the frequency of potentially profitable points in time. For example, a minimum return assumption of 50% occurred 51.7% of the time during my study. This model generated an ultimate portfolio value of $218,896 (5.36% compounded annually). In comparison, $100,000 invested in XIU would have returned $225,792 (not including reinvested dividends).
The XIU/straddle comparisons are instructive because they provide a foundation to demonstrate the long-term benefits of holding a long straddle/treasury bill portfolio as a volatility substitute within an all-equities mandate.
The straddle portfolio (i.e., using the 50% return assumption, with 5% capital invested in each straddle) had an annual standard deviation of 11.1%. A portfolio of Canadian stocks that are highly correlated to the XIU had an annual standard deviation of 20%, over the past 15 years.
If we had constructed a mandate that was equally split between the straddle portfolio and XIU, then rebalanced once a year, the standard deviation for the mandate would have come in at 11.3%. More to the point, the combined portfolio would have produced an ultimate value of $248,815 (not including reinvested dividends), which is greater than the ultimate values for the component parts, thus achieving alpha.
When we break down the components of our theoretical portfolio, what we have is a mandate that is approximately 50% equities, 40% T-bills and 10% straddle buying, which is similar to a typical balanced portfolio of 50% equities, 40% bonds and 10% cash. However, in a low interest rate environment, the XIU/straddle combination will produce better results.IE
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